High capex companies are usually bad investments as they rarely produce enough free cash flow

Supermarket companies, in general have consistently spent more on capex than depreciation and produced very low free cash flow per share compared with EPS for many years.

For example:  Sainsbury's 

Sainsbury's has regularly spent more on capex than its depreciation expense for the period 2006 to 2015.  At the same time, it has reported no meaningful growth in profits as measured by EPS.

Its capex to depreciation ratio for 2006-2015 ranged from 120% to 240%.   

Despite all this investments (capex), EPS has not grown (In 2010 EPS was 30 p  and in 2016 EPS was 22.5p.) and its FCFps has been negative for every one of these ten years,   

Question to ponder

How much of the money spent on capex was to grow the business and how much was needed to maintain its existing assets and sales?

If most of this capex was actually needed for maintenance, then Sainsbury's depreciation expense may have been too low and its profits too high.   

Take home point

Regardless of what the reason is for the high capex, these kind of companies are usually bad investments as they rarely produce enough free cash flow.

The above situation probably explains why Sainsbury's share price went nowhere over a 10-year period from 2005 and 2015 and why Sainsbury's had to cut its dividend payment to shareholders.

How depreciation of assets can distort profit figures

Depreciation is an expense that matches the cost of a fixed asset against the revenues it helps to produce.  The cost of an asset is spread over its useful life.   

The most common method of depreciating an asset is known as straight-line depreciation, where an equal amount is charged against revenue over the asset's useful life and is calculated as follows:

straight line depreciation = (cost - residual value) / estimated useful life

Depreciation is often seen as a proxy for maintenance or stay in business capex.  

The problem with depreciation is that the management of a company can make it whatever value they want.  The easiest way to do this is to say that assets will last longer than they will in reality.

Example

If an asset costs $10 million and will last for 10 years and be worth nothing after that time, the depreciation expensed against revenues for the next 10 years will be, $1 million per year.

($10 m - $ 0)/10 years = $1 million per year

In order to maintain the value of assets at $10 million, the company will have to spend $1 million on new assets each year (the amount it has depreciated by).  

This is why depreciation is often seen as a proxy for maintenance or stay in business capex.

What if the $10 million asset only really lasts 5 years?   

Depreciation should be $2 million per year instead of $1 million and profits should be $ 1 million lower.  

If a company depreciates an asset by $1 million a year but actually spends $2 million to keep the asset up to date, then capex will be twice as much as depreciation but profits will be overstated by $1 million.  

This will be picked up in the FCFps number but not the EPS.

Looking for possible investment candidates: Four simple rules when comparing FCFps with EPS

 Summary

Expenses and depreciation reduce profits.  Capex reduces FCF.

When expenses are not expensed against revenues but considered as capex, the company will report higher profit.  Also, the depreciation charge reported by the company will be probably too low.

In a nutshell:

• the cash spent should be expensed against revenues and so it should reduce profits.  
• unless it does, this, the depreciation charge reported by the company is probably too low and profits too high.   

Four simple rules when comparing FCFps with EPS when looking for possible investment candidates:

1.  Definite candidate:  FCFps is 80% or more of EPS

2.  Possible candidate:  FCFps less than 80% of EPS and ROCE is increasing

3.  Avoid:  FCFps less than 80% of EPS but ROCE is falling 

4.  Avoid:  FCFps is consistently negative.

If free cash flow per share is consistently a lot lower than EPS, this is a warning sign.

 The 2 main reasons for FCF being lower than a company's EPS are:

1.  Poor operating cash conversion

2.  High levels of investment in new assets.

Poor operating cash conversion

This tends to occur when a company is growing quickly and sells a lot of its goods and services on credit.

The profits on these sales get booked in the income statement but there are no cash flows until the customer pays.

Companies may also build up stocks or inventories in anticipation of selling more.  This is fine as long as the reason is genuine.

But building up stocks is also a good way for companies to shift overhead costs such as labour away from the income statement in order to boost profits.  This can happen when companies include the overhead costs of producing stock in the balance sheet value.  If the stock is unsold at the year-end that overhead cost has not been expensed through the income statement and can therefore boost profits.  

Selling products on credit can be a sign of overtrading, or even fictitious sales.  This sort of thing never turns out well for shareholders, so you need to watch out for this.

2.  High level of investment in new assets

This is when capex is much higher than depreciation.

Depreciation reduces profits, but money spent on capex reduces free cash flow.

In this case, free cash flow per share will be a lot less than EPS.

• Capex that is consistently higher than depreciation with improvement in ROCE

It is not necessarily a problem for a company to spend heavily on capex, as long as the capex is earnings a decent ROCE.  

[Example:   Easyjet in 2015.  Its FCF per share was less than its EPS due to capex being significantly more than depreciation.  However, this is not a cause for worrying too much, as the company's ROCE had been increasing at the same time.]

• Capex that is consistently higher than depreciation with NO improvement in ROCE

However, capex that is consistently much higher than depreciation with no improvement in ROCE is rarely the hallmark of a great company.  

It can be a sign of dodgy accounting as companies can and do shift expenses into capex to boost profit.

When FCF per share is a lot less than EPS it may also be a sign that a company is manipulating its profits to make them look bigger than they really are.  

In these cases, capex is often much higher than depreciation but the company might be spending this cash just to maintain its existing assets, rather than using the expenditure to enhance it s income-producing assets.

• In a nutshell, the cash spent should be expensed against revenues and so it should reduce profits.  
• Unless it does, this, the depreciation charge reported by the company is probably too low and profits too high.   

Quality companies turn most of their profits into free cash flow on a regular basis

We can use free cash flow as a tool for checking the quality of a company's profits.

The stock market has been littered with companies that seemed to be very profitable but turned out to be anything but.

Investors can save themselves a lot of heartache and some painful losses by taking a few minutes to study how effectively a company converts profits into free cash flow.

One of the simplest and best ways to test the quality of a company's profits and whether you think they are believable or not is to compare a company's underlying or normalised earnings with its free cash flow.   

The free cash flow will show you how much surplus cash the company has left over to pay shareholders.  It can often be very different from EPS, even though it is supposed to tell you the same thing.  For most years, you want to see the free cash flow has been close to earnings.

Calculating free cash flow

Example:  Company Z ($ m)

Net cash flow from operations  69.0

Capex -6.8

FCF to the firm (FCFF) 62.7

Minority or preference dividend paid 0.0

Interest paid -0.3

Interest received 0.0

FCF for shareholders (FCF)  62.4

Weighted average number of shares in issue  504.6m

FCF per share 12.37 sen

Underlying EPS  11.9 sen

Quality companies turn most of their profits into free cash flow on a regular basis

Checking the safety of dividend payments

Dividends are an important part of total returns from owning a share.  

Dividends are a cash payment and therefore the company needs to have enough cash flow to make these payments.

Compare the FCF with its dividends

By comparing the free cash flow with its dividends, you can see whether a company has sufficient cash to pay dividends.  

Net cash from operation - CAPEX =  Free Cash Flow

You want to see the free cash flow being the bigger number more often than not.

When dividend is the larger number compared to the free cash flow, this may occur when a company is putting cash to good use (capex).  When dividend  is the larger number is fine on occasional years.  Prolonged periods of insufficient free cash flow will often lead to dividends being cut or scrapped eventually.

When analysing a company, it is often a good idea to compare free cash flow with the dividends over a period of ten years.

FCF dividend cover

A quick way to check whether cash flow is sufficient to pay dividends is by using the free cash flow dividend cover ratio.   This is calculated as follows:

Free Cash Flow dividend cover =  Free cash flow / dividends.

When free cash flow exceeds the dividends by a big margin, it can be a sign that the company may be capable of paying a much bigger dividend in the future.

When free cash flow may not be what it seems

Free cash flow comes with a few caveats one need to be aware of.

Besides calculating a company's free cash flow, one need to study its cash flow statement closely to really find out what is going on.

Example:  Company Property X - no free cash flow but paying dividends

Operating profits  830m

Other (operating) (648m)

Operating cash flow 182m

Tax paid -

Net cash from operations 182m

Capex (441m)

Free cash flow (259m)

Equity dividends paid (139m)

This is a property company.  Making money from selling properties (assets) is a normal part of its day-to-day activities.  It makes sense to consider the sales of assets a part of the free cash flow.

Free cash flow (259m)

Add back asset sales 1,358m

ADJUSTED FCF  1,099m

Equity dividends paid (139m)

This company is more than able to pay its dividends to its equity owners.  

Always need to study the cash flow statements to understand what is really going on.

Example:  Company Serial-Acquirer Y - lots of free cash flow but regularly buying companies

Occasionally, one comes across companies that seem to be producing lots of free cash flow when in reality they are not.

If you study the investing section of the cash flow statement more closely, large cash outflows might not be found in the capex section but can be found somewhere else,  such as acquisitions.

Operating profits 46.3m

D&A 13.1m

Profits on disposals (1.6m)

Change in working capital `1.3m

Other (operating) 1.3m

Operating cash flow 57.9m

Tax paid (14.4m)

Net cash from operations 43.5m

Capex (6.9m)

Free cash flow 36.6m

Equity dividends paid (9.7m)

This is a company that keeps spending a lot of money on acquisitions regularly and yearly.

Acquisition (18m)

ADJUSTED FCF 18.6m

For this company, the cash spend on acquisitions should probably be used to calculate free cash flow, in order to give a fair picture.   When this is done, its free cash flow is significantly reduced.  

This company may be too reliant on buying other companies to produce the cash flow needed to pay its dividend.  Before looking at this company as a potential investments, one would certainly want to investigate this further.

Is it inexpensive? Four different price metrics:

#Nothing is worth infinity. 

We can overpay for even the best of companies.

So even if we understand a business (first step) and find it to be good (second step) we can still make a bad investment by paying too much.

The third step in the value investing model asks a final fundamental question: Is it inexpensive?



Inexpensiveness can be detected with four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)



#Price metrics

1.  Times free cash flow. 

It equals a company’s market capitalization divided by its levered free cash flow. It’s abbreviated
MCAP/FCF.

The denominator, levered free cash flow. 

• It’s cash flow from operations minus capex. 
• Note that it captures the payment of both interest and taxes.

The numerator, market capitalization, is often shortened to market cap.

• It’s the number of shares outstanding times the current price per share.

Notice the consistency between numerator and denominator.

• Market cap is the price for the equity only. 
• Levered free cash flow is the cash thrown off by the business after debtholders have been paid their interest.  Hence levered free cash flow goes to the equity holders.

Theoretically, market cap is what it would cost to buy all of a company’s outstanding shares.

• But it’s actually an underestimate. 
• That’s because the current share price reflects only what some shareholders were—moments ago—willing to take for their stock. 
• Most are holding out for more.

2.  Enterprise value to operating income. 
It’s abbreviated EV/OI.

The denominator, operating income. 

• It’s revenue, minus cost of goods sold, minus operating expenses. 
• Note that it’s not net of interest or tax expenses.

The numerator, enterprise value, is the theoretical takeover price.

• It’s what one would fork over to buy the entire company, not just the outstanding shares.
• Paying it would leave no one else with any financial claim on the company. 
• There’d be no outside common stockholders, no preferred shareholders, no minority partners in subsidiaries, no bondholders, no bank creditors, no one.

Enterprise value is a tricky concept, for two reasons.

1.  First, it’s derived in part from current market prices.

• So in name, it defies the value investing distinction between price and value. 
• The term enterprise price would make more sense.

2.  Second, it’s harder to calculate.

• In essence, it equals market cap plus the market price of all of the company’s preferred equity, noncontrolling interest, and debt and minus cash.

Like market cap, the enterprise value of a particular company is given on financial websites. Such off-the-shelf figures are convenient. But if a company looks promising, it’s wise to calculate enterprise value longhand. To see why, consider its components.



3.  Price to book. 
It equals market cap divided by book value. It’s abbreviated MCAP/BV.

Book value, recall, equals balance sheet equity.


4.  Price to tangible book value, or MCAP/TBV. 
It’s MCAP/BV with intangible assets removed from the denominator.   Patents, trademarks, goodwill, and other assets that aren’t physical get subtracted.

MCAP/TBV is a harsher measure than MCAP/BV.

• It effectively marks any asset that can’t be touched down to zero. 
• Some situations are better suited to this severity than others. 

To see which ones, we revisit goodwill.

Recall that goodwill equals acquisition price in excess of book value.

• We gave the example of company B having book value of $1,000,000; company A acquiring it for $1,500,000 in cash; and company A increasing the goodwill on its balance sheet by $500,000.

Note the assumption embedded in this practice.

• Goodwill is an asset. 
• So in buying company B and goodwill, company A is swapping assets for assets. That’s how accounting sees it. 
• No expense is recognized on the income statement, and no liability is booked on the balance sheet. 
• Nothing bad occurs.

#What’s inexpensive, and what isn’t?

1.  MCAP/FCF and EV/OI

When we calculate price metrics, we get actual numbers. MCAP/FCF may be 5, or 50. EV/OI may be 3, or 30. What’s inexpensive, and what isn’t?

I like MCAP/FCF to be no higher than 8, and EV/OI to be no higher than 7.  

Before moving on to benchmarks for the other two price metrics, let’s understand what these first two multiples mean.

• Imagine that a company’s future operating income will be $1,000,000 for each of the next 100 years. Discounting that stream back at—say—10 percent yields $9,999,274.
• That quantity, $9,999,274, is nearly $10 million. Notice that $10 million is 10 times the forecasted annual operating income.
• So if one calculates a company’s EV/OI as 10, that could mean that the market thinks operating earnings will be $1,000,000 for each of the next 100 years, and 10 percent is the right discount rate.
• Or, it could be mean that the market thinks operating income for the next 100 years will grow 4 percent annually from a $1,000,000 base, and that 14 percent is the right discount rate.

In other words, multiples are shorthand. 

• They’re shorthand for a formal present value analysis. 
• In them are embedded beliefs about growth rates and discount rates.

Holding everything else equal, it’s better to own a company with income that’s growing than one with income that isn’t. 

So when I say that I want EV/OI to be no higher than 7, what I’m saying is that I’ll only buy a stream of future operating income when it’s offered to me at a high discount rate.

Of course one never knows just what future operating earnings will be. Same with free cash flow. And where the exact discount rates come from isn’t important.

What is important is this: 
"low price multiples signal buying opportunities to the value investor when they reflect unjustifiably high discount rates."

2.  MCAP/BV and MCAP/TBV

The other two price metrics, MCAP/BV and MCAP/TBV, are a little different. 

• They don’t reflect a stream of future anything. 
• They’re multiples of what a company has now.

I prefer both MCAP/BV and MCAP/TBV to be no higher than 3.

But these are just qualifiers for me. They’re not what I look for.

What I look for is MCAP/FCF and EV/OI. 

It’s worth exploring why.


#Why MCAP/FCF and EV/OI are preferred to MCAP/BV and MCAP/TBV?

I aim to own companies that continue as going concerns.

• I want them alive. 
• Profitable ones are worth more that way. 

But MCAP/BV and MCAP/TBV express price relative to the value of companies dead. 

• If a firm stopped operating and sold everything—if it liquidated—the total amount available to distribute to shareholders would have something to do with its book value. 
• But when I buy a stock, I don’t hope for a stake in some dead company’s yard sale. I’m buying a claim on future streams of income and cash flow.

This isn’t to say that MCAP/BV and MCAP/TBV are useless. They can uncover opportunities. 

• Say that a company’s EV/OI is 9, and that both MCAP/BV and MCAP/TBV are 6. 
• The company doesn’t look inexpensive. 
• But MCAP/BV and MCAP/TBV are the same. 
• This leads the astute investor to see if the company owns some juicy tangible asset like land that’s carried on the balance sheet at a tiny, decades-old purchase price. 
• Will the company sell the land for cash? 
• Will that cash be excess? 
• If so, all of the price metrics could plunge. That’s the kind of useful thinking that the dead metrics tease out.

#The first step is to understand a business and the second step is to find it to be good; then valuation

Putting forth my benchmarks so bluntly—8, 7, 3, and 3—is a little dangerous and potentially misleading.

It’s dangerous because it could be interpreted to mean that it’s OK to cut right to valuation without first understanding a business and seeing if it’s good.  Many investors do that. And it can work. But with that approach mine are not the benchmarks to use.





Summary

Inexpensiveness can be detected with four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)

KEY INPUTS TO FREE CASH FLOW (FCF)

KEY INPUTS TO FREE CASH FLOW (FCF)

Free Cash Flow (FCF) is calculated by taking the Operating Income (EBIT) for a business, minus its Taxes, plus Depreciation & Amortization, minus the Change in Operating Working Capital, and minus the company’s Capital Expenditures for the year. This derives a much more accurate representation of the Cash that a company generates than does pure Net Income:

FCF = EBIT x (1-tax) + D&A - Changes in Working Capital - Capex

How to find Quality Companies? (Checklist)

Here is a useful checklist you can use when you are searching for quality companies:

1.   Company's sales record.

• You want to see high and growing sales, year after year.
• A ten-year period of increasing sales and profits is a good sign.

2.  Company's profits.

• You want to see high and growing profits, as measured by normalised EBIT, year after year.
• A ten-year period of increasing sales and profits is a good sign.

3. EBIT and normalised EBIT 

• Check that these are roughly the same in most of the last ten years.

4.  EBIT margin.  

• The EBIT margin must be of at least 10% almost every year for the last ten years.

5,  ROCE

• The company must have a ROCE that is consistently above 15% over the last ten years.
• ROCE = (EBIT / average capital employed ) x 100%

6.  DuPont analysis

• Carry out a DuPont analysis to find out what is driving a company's ROCE.
• ROCE = EBIT/Capital Employed = (EBIT/Sales) x (Sales/Capital Employed)
• ROCE = {Profit margin x Capital turnover)

7.  Annual report

• Read a company's annual report to provide context for the numbers.

8.  FCFF and FCF

• Look for a growing free cash flow to the firm (FCFF) and free cash flow for shareholders (FCF), over a period of ten years.
• FCFF and FCF should also be roughly the same in most years.
• That is, little debt.

9.  Operating cash conversion ratio 

• Look for companies that turn all of their operating profits (EBIT) into operating cash flow, as represented by an operating cash conversion ratio of 100% or higher.
• Operating cash conversion ratio = (operating cash flow / operating profit) x 100%
• That is, high quality earnings

10.  Capex ratio

• Look for capex ratio less than 30% almost every year over the last ten years.
• That is, low capex requirements.
• Capex ratio = Capex / Operating Cash Fow

11.  Compare Capex to its depreciation and amortisation expenses.

• If the company is spending more on capex than its depreciation and amortisation expenses, it is a sign that it is spending enough but you need to be sure it isn't spending too much.

12.  FCFF/Capital Employed or CROCI

• Check for free cash flow to firm return on capital invested that is higher than 10% almost every year over the last ten years.
• This is also known as cash-flow return on capital invested (CROCI)
• CROCI = adjusted free cash flow tot he firm (FCFF)/average capitl employed

13.  Compare FCFps to EPS

• Look for free cash flow per share to be close to earnings per share in most of the last ten years.
• That is, high quality earnings.

14.  Free cash flow dividend cover

• Free cash flow per share should be a larger number than dividend per share in most years.
• That is, the free cash flow dividend cover should be greater than 1.
• Free cash flow dividend cover = FCFps / DPS
• Occasional years when this is not the case are fine.

15.  Consistent Growth

• Prefer more consistent growth in turnover and profit to more volatile growth.

Comments:


Don't worry if you cannot find a company that meets ALL of the criteria above.

There are some exceptional companies that do.

Typically you will not find hundreds of them.

Companies can improve and the ones that might not have been good ten years ago can be good companies now.

If you can find companies that have a high and improving ROCE and have been good at converting profits into free cash flow over the last five years, you should consider them as well.

Quality companies turn most of their profits into free cash flow on a regular basis.

The stock market is littered with companies that seemed to be profitable but turned out to be anything but.

By studying how effectively a company converts profits into free cash flow,  you can save yourself a lot of heartache and painful losses.

One of the simplest and best ways to test the quality of a company's profits (high quality earnings) and whether you think they are believable or not is to compare a company's underlying or normalised earnings per share (EPS) with its free cash flow per share (FCFps).

The free cash flow per share will show you how much surplus cash the company has left over to pay shareholders.

It can often be very different from EPS, even though it is supposed to tell you the same thing.

For many years, you want to see that free cash flow per share has been close to EPS.

How to calculate the Free Cash Flow to Firm and Free Cash Flow to Shareholders

There are two definitions of free cash flow, both of which are useful for investors:

1.  Free cash flow to the firm (FCFF)
2.  Free cash flow for shareholders (FCF).

Free cash flow for shareholders is also referred to as free cash flow for equity.

These can be calculated very easily from a company's cash flow statement.


FCFF

To calculate FCFF, take a company's cash flows from operating activities, add dividends received from joint ventures and subtract tax paid to get the net cash flow from operations.  The subtract capex.

Net cash from operations
less Capital expenditure
add Dividends from joint ventures
= FCFF



FCF

To calculate the FCF, take the FCFF number and subtract net interest (interest received less interest paid), any preference share dividends, and dividends to minority shareholders.


FCFF
less dividends paid to minorities
less interest paid
add interest received
=FCF




When FCFF is not much different from FCF

A company with very little debt and thus, a tiny interest payment, virtually all of the free cash flow produced by the business (FCFF) becomes free cash for the shareholders (FCF).

In such a company, there is not much difference between FCFF and FCF.

This is a positive sign for investors and investors should look for this sort of situation in companies they are analysing.


When FCFF is consistently different from FCF

A company with a lot of borrowings has high interest bills to pay.

In this company, the FCFF and FCF can be consistently different for many years.

This is because the interest payments eat up a big chunk of the company's FCFF, leaving less FCF for shareholders.




Avoid companies with lots of debt

In general, it is a good idea to avoid companies with lots of debt.

• Too much of their free cash flow to the firm can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their free cash flows to repay debt and lower their future interest bills.

• This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Additional notes

Free cash flow to the firm (FCFF)

The amount of cash left over to pay lenders and shareholders.

Operating cash flow less tax and capex.


Free cash flow (FCF)

The amount of cash left over after a company has paid all its non-discretionary costs.

It is the amount of cash that the company is free to pay to shareholders in a year.

Operating cash flow less tax and capex, interest paid and preference dividends.

Comparing average capex spending with depreciation and amortization.

1.   Where depreciation and amortization <<< capex

In some cases, the annual depreciation and amortization expense is a lot less than the average five- or  ten-year capex.#

This is the case in asset intensive companies.

When you see this, you have two good reasons against investing in them.  It should not be surprising that these companies

• have very poor free cash flow track records and 
• modest ROCE performances.

Avoid these companies, unless they have been able to produce a good ROCE whilst investing heavily.


2.  Where depreciation and amortization >>> capex.

Normally, you should be suspicious of companies with this kind of behaviour.

Is this a company that has been under-investing?

If yes, this could hurt its ability to make more money in the future.

However, you need to study the company's history on this issue to make sure that it is not under-investing.

Some companies have to spread the cost of things over their useful lives, (for example the costs of a TV channel such as licences, customer contracts, software and programme libraries), which don't need to be matched by outflows of cash every year.   



# As a rough rule of thumb, if the five-year capex figure is higher than the ten-year average, you should use the higher figure.

Calculating Owner Earnings of Buffett or the Company's Cash Profits

Buffett in his 1986 letter to shareholders described how he worked out what he called the "owner earnings".   

This is also referred to as the cash profits of a business.

Buffett believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.



How to calculate owner earnings or cash profits of a business?

Owner earnings are calculated as follows:

Owner earnings =   net income
                               + depreciation & amortisation
                               + other non cash item
                               - maintainance capital expenditure.


Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintainance, or stay in business, capex) often exceeded the depreciation and amortisation expense, and therefore profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintainance capex figure.



The difference between Owner Earning of Buffett and FCF

Generally speaking, in the owner earnings of Buffett or cash profits of a business, the calculation ignores changes in working capital that are included in free cash flow.



Hardest part of calculating owner earnings is estimating maintainance or stay in capex

The hardest part of this calculation is trying to estimate what maintainance or stay in business capex is.

As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.

But the good thing is, you don't need to.

The whole purpose is to get a figure for the amount of cash needed to keep fixed assets in good working order so that you can then have a conservative estimate of cash profits to value a company

Basing your valuation on a conservative figure is more prudent and lowers your changes of paying too much for a share, which in turn lowers your investment risk.

(Additional notes below)



What to do when the owner earnings or cash profits of a business are negative?

If you come across a company that looks as if it is losing money when estimating its cash profits you need to either

• do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or 
• look for another share to buy.

Summary:

In summary, here is what you need to do in calculating owner earnings or company's cash profits:

1.  Take the company's most recent annual underlying or normalised net income/profit.

2.  Add back depreciation and amortization.

3.  Take away an estimate of stay in business capex.

4.  Divide by the weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.


Knowing a company's cash profits, we can use these to value shares.  




Additional Notes:

How do you get an estimate of stay in or maintainance business capex?

There are 3 reasonable methods:

1.  The company tells you.

Some companies are very good at simply stating what the figure is.  They give this figure in their annual reports.

2.  Use a multiple of the current depreciation or amortization expense.

Use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate, sometimes.

For some companies, it can be way off if the cost of replacing assets is falling.

3.  Use a five or ten-year average of capital expenditure or capex.

This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.

This is a good approach to use if the company does not state the figure outright.

The Free-Cash-Flow to-Equity (FCFE) Model

Many analysts assert that a company's dividend-paying capacity should be reflected in its cash flow estimates instead of estimated future dividends.

FCFE is a measure of dividend paying capacity.

It can also be used to value companies that currently do not make any dividend payments.

FCF can be calculated as:

FCFE = CFO - FC Inv + Net borrowing


Analysts may calculate the intrinsic value of the company's stock by discounting their projections of future FCFE at the required rate of return on equity.




Reference:

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity

How to Value a Company in 3 Easy Steps

How to Value a Company in 3 Easy Steps - Valuing a Business Valuation Methods Capital Budgeting


Valuing a Business
How much is a business worth?
Don't care about the 'asset value' or 'owner equity' of the business.
We look at the present value of its net free cash flows (FCF) plus present value of its horizon value".



Step2 - How to Value a Company for Valuing a Business Valuation Methods Capital Budgeting



Step3 How to Value a Compay for Valuing a Business Valuation Methods Capital Budgeting

Uploaded on 15 Mar 2010

Clicked here http://www.MBAbullshit.com/ and OMG wow! I'm SHOCKED how easy.. 

Just for instance I possessed a company comprising of a neighborhood store. To put together that center, I invested $1,000 one year ago on apparatus along with other assets. The equipment in addition to other assets have depreciated by 10% in a single year, so now they're valued at only $900 inside the accounting books. In case I was going to make an effort to offer you this company, what amount would an accountant value it? Relatively easy! $900. The cost of the whole set of assets (less liabilities, if any) can give accountants the "book value" of a typical organization, and such is systematically how accountants observe the worth of an enterprise or company. (We employ the use of the word "book" because the worth of the assets are penned within the company's accounting "books.") 
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However, imagine this unique company is earning a juicy cash income of $2,000 annually. You would be landing a mighty incredible deal in the event I sold it to you for just $900, right? I, on the flip side, might be taking out a pretty sour pact in the event I offered it to you for just $900, on the grounds that as a result I will take $900 but I will shed $2,000 per annum! Due to this, business directors (dissimilar to accountants), don't make use of merely a company's book value when assessing the value of an organization.So how do they see how much it really is worth? To replace utilizing a business' books or even net worth (the market price of the firm's assets minus the business enterprise's liabilities), financial managers opt to source enterprise worth on how much money it gets in relation to cash flow (real cash acquired... contrary to only "net income" that may not generally be in the format of cash). Basically, a company making $1,000 "free cash flow" monthly having assets worth a very small $1 would remain to be worth a great deal more versus a larger company with substantial assets of $500 in the event the humongous company is attaining only $1 yearly.So far, how do we achieve the exact value of your business? The simplest way would be to mainly look for the net present value of the total amount of long run "free cash flows" (cash inflow less cash outflow).Needless to say, you will come across much more sophisticated formulas to find the value of a company (which you wouldn't genuinely need to learn in detail, since there are numerous gratis calculators on the web), but practically all of such formulas are in a way driven by net present value of cash flows, plus they are likely to take into consideration a few factors for example growth level, intrinsic risk of the company, plus others.

A practical analysis of dividend

A Practical Analysis Of Unilever Plc's Dividend

By Royston Wild | Fool.co.uk

The ability to calculate the reliability of dividends is absolutely crucial for investors, not only for evaluating the income generated from your portfolio, but also to avoid a share-price collapse from stocks where payouts are slashed.

There are a variety of ways to judge future dividends, and today I am looking at Unilever (NYSE: UL - news) to see whether the firm looks a safe bet to produce dependable payouts.

Forward dividend cover

Forward dividend cover is one of the most simple ways to evaluate future payouts, as the ratio reveals how many times the projected dividend per share is covered by earnings per share. It can be calculated using the following formula:

Forward earnings per share ÷ forward dividend per share

Unilever is expected to provide a dividend of 88.8p per share in 2013, according to City numbers, with earnings per share predicted to register at 139.1p. The widely-regarded safety benchmark for dividend cover is set at 2 times prospective earnings, but Unilever falls short of this measure at 1.6 times.

Free cash flow

Free cash flow is essentially how much cash has been generated after all costs and can often differ from reported profits. Theoretically, a company generating shedloads of cash is in a better position to reward stakeholders with plump dividends. The figure can be calculated by the following calculation:

Operating profit + depreciation & amortisation - tax - capital expenditure - working capital increase

Free cash flow increased to €5.14bn in 2012, up from €3.69bn in 2011. This was mainly helped by an upswing in operating profit -- this advanced to €7bn last year from ?6.43bn in 2011 -- and a vast improvement in working capital.

Financial gearing

This ratio is used to gauge the level debt a company carries. Simply put, the higher the amount, the more difficult it may be to generate lucrative dividends for shareholders. It can be calculated using the following calculation:

Short- and long-term debts + pension liabilities - cash & cash equivalents

___________________________________________________________            x 100

                                      Shareholder funds

Unilever's gearing ratio for 2012 came in at 56.6%, down from 59.5% in the previous 12 months. The firm was helped by a decline in net debt, to €7.36bn from €8.78bn, even though pension liabilities edged higher. Even a large decline in cash and cash equivalents, to €2.47bn from €3.48bn, failed to derail the year-on-year improvement.

Buybacks and other spare cash

Here, I'm looking at the amount of cash recently spent on share buybacks, repayments of debt and other activities that suggest the company may in future have more cash to spend on dividends.

Unilever does not currently operate a share repurchase programme, although it remains open to committing capital to expand its operations around the globe. Indeed, the company is attempting to ratchet onto excellent growth in developing regions as consumer spending in the West stagnates -- the firm saw emerging market sales rise 10.4% in quarter one versus a 1.9% fall in developed regions.

The firm remains dogged in its attempts to acquire a 75% stake in India's Hindustan Unilever (BSE: HUL.BO - news) , for example, and I expect further activity to materialise in the near future. Meanwhile, Unilever is looking to reduce its exposure to stagnating markets by divesting assets, exemplified by the recent sale of its US frozen foods business.

An appetising long-term pick

Unilever's projected dividend yield for 2013 is bang in line with the FTSE 100 (FTSE: ^FTSE - news) average of 3.3%. So for those seeking above-par dividend returns for the near-term, better prospects can be found elsewhere. Still, the above metrics suggest that the firm's financial position is solid enough to support continued annual dividend growth.

And I believe that Unilever is in a strong position to grow earnings strongly, and with it shareholder payouts, further out. Galloping trade in developing markets, helped by the strength of its brands -- the company currently boasts 14 '€1 billion brands' across the consumer goods and food sectors -- should significantly bolster sales growth and thus dividend potential in my opinion.

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> Royston does not own shares in Unilever. The Motley Fool has recommended shares in Unilever.

http://uk.finance.yahoo.com/news/practical-analysis-unilever-plcs-dividend-090040474.html

Alternative to Discounted Cash Flow Method

What do you use if you don't want to or can't use the discounted cash flow (DCF) method of valuing a stock?  

There are other methods for valuing a stock (not valuing the company).  The most popular alternative uses various multiples to compare the price of one stock to a comparable stock.

The price earnings ratio (P/E) is the most popular multiple for these comparisons.

You can use the P/E formula to find the price based on comparable stocks.

For example, three stocks in a particular industry had an average P/E of say 18.5.  If another stock ABC in the same industry had earnings of $2.50 per share, you could calculate a stock price of $46.25 per share (= 2.5 x 18.5).  This is just an approximation, but it should put stock ABC on a comparable basis with the other three stocks in the same industry.



This strategy has several flaws.

1.  The P/E is not always the most reliable of value gauges.
2.  The process depends on the three comparables being priced correctly and there is no guarantee of that.
3.   Its biggest flaw is that the process tells you nothing of the future value of the company or the stock.

If you use this method, and many investors do, you will need to watch the stock more closely and continually measure it against comparables.  However, it does not require you to estimate anything or consider multiple variables, which is why it is so popular.

This method is best used for a quick decision on whether the stock is under-priced or over-priced.
Although you can arrive at a stock price based on the P/E formula, it is not nearly as accurate as the DCF method.



You can also use other key ratios in valuation.

These include the followings:
1.  Price/Book - Value market places on book value.
2.  Price/Sales - Value market places on sales.
3.  Price/Cash Flow - Value market places on cash flow.
4.  Dividend Yield - Shareholder yield from dividends.



So, which method should you use - DCF or multiples?

In the end, you will have to decide which method is for you.

There is no rule against using both.

Whether you calculate your own DCFs or use the estimates from others, reputable websites or analysts estimates, make sure you have the best guess available on the variables the formula needs.

Either way, make a conscious decision to buy a stock based on the valuation method of your choice and not a "feeling" for the stock.

Warren Buffett's Owner's Earnings Calculation

The number the directors don't want you to find

FCF (Free Cash Flow)

You can use this FCF in the following manners, by comparing it with the EPS, DPS and Market Price per share:

1.  Compare FCF/share with EPS
e.g.  FCF/share divided by EPS = 80%.

2.  Divide FCF/share by the DPS (Dividend per share)
e.g.  FCF/share divided by DPS = 1.6x
This looks at the ability of the company to distribute dividends by looking at its free cash flow.

3.  FCF yield.
e.g.  FCF/share divided by Market share price/share = 5.3%.
Where the FCF yield is high, the investors should be attracted to the stock.