Free cash flow, debt, and the oil services industry, cont.
1) Chuzzlewit, I too am conservative where debt is concerned, but I still say that the oil services industry, with an average debt/equity of .4, looks pretty good in this respect, better than most industries (except semi-conductors and software). Just out of curiosity, I checked out other industries where I have more than one holding: home and office furniture (average .5); computers (.57); retail stores (.57); cement (.57); pharmaceuticals (1.30). I won't even go into the higher-debt industries, like auto manufacturers (4.39).
2)As for your definition of free cash flow, my question is -- why select just one form of debt ("sinking fund")? Doesn't a company have to pay back everything that it owes out of cash, sooner or later? (When I apply for a mortgage, for example, the mortgage company wants to know about every debt I could possibly have.)
3) Of course, I agree that the major problem with using the "net income plus depreciation/amortization minus necessary capital expenditures" definition of free cash flow is that it is difficult to distinguish "necessary" from "discretionary" capital spending. Consequently,in practice web financial reporting services generally deduct all capital spending, necessary or not, to get their free cash flow number.
4) The advantage of using this method is that you don't have to calculate it yourself for each individual company. You can get a readily supplied number from whatever service you prefer. Let me elaborate on that:
5) You have an investor, say -- an intelligent person, but not a financial specialist or an accountant or a mathematician. This investor, Mr. G, let's say, wants to narrow down the universe of stocks out there, to find candidates for investment. So Mr. G. runs a search for companies that meet certain criteria: let's say, annual eps/sales/cashflow growth of more than x% annually; low debt; AND positive free cash flow. That narrows the field down considerably, and Mr. G. can then investigate the candidates he's turned up more thoroughly, by going to annual reports, etc. Your method of estimating free cash flow may be good, but is too idiosyncratic to be of any use to Mr. G. in his initial search for investment candidates. So, what (generally accepted) criteria would you propose Mr. G. use in his initial -- crude but useful -- search? (Actually, you have already mentioned some of them: see below.)
6) Compulsive searcher that I am, I ran a search for companies meeting the two generally accepted criteria that you did mention: 1) debt/equity from 0.0 to 0.3; 2) lowest possible price/cash flow ratio. Among those that came up: Microsoft, Cisco, Ascend, Washington Post Co., Liz Claiborne, Adobe, De Beers, HBO & Co., Wrigley, Walgren, Cabletron, Parametric, Amway Japan, Oxford Health (Oh, no -- watch out for that last one! Lost my shirt! Free cash flow, defined my way, turned sharply negative -- and then, WHAM, BAM!). Oops - I forgot - you also mentioned PEG ratio. Some of the mentioned companies would not do too well on that one, so I'll have to run another search.
jbe (aka Mr. G)
P.S. Have you read Hackel & Livnet's "Cash Flow and Security Analysis"? |
