Big Capital Spending and Cash Flow Can Work Together

Company ABC.

1995  Earnings    $100,000        FCF -$7.0million
1996  Earnings    $5.9million      FCF -$28.0million
1997  Earnings    $12.3million    FCF -$57.4million


Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.




Company OPQ.



1997  Earnings    $6,945million     FCF  +$5,507million
1998  Earnings    $6,068million     FCF  +$5,634million
1999  Earnings    $7.932million     FCF  +$7,932million 


Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.






Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  


Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.  


Both Company ABC and Company OPQ spend vast sums relative to their asset bases.  However, we see a big difference when we look at their respective FCFs.

• These positive FCFs mean Company OPQ has money left over even after its large capital-spending budgets.  
• By contrast, Company ABC, must turn to investors or lenders to make up the difference.  Only by selling new shares to the public or taking out a loan can Company ABC fund its aggressive spending.

What free cash flow tells you

What free cash flow (FCF) tells us that earnings don't?

Let us have a look at Company ABC.

From 1995 through 1997, the company posted $100,000, $5.9 million, and $12.3 million in earnings.  Nice growth, right?

The company's FCF, by contrast, was negative $7.0 million, negative $28.0 million, and negative $57.4 million.  FCFs also grew - but in the opposite direction as earnings.

That's not necessarily bad.

FCF is equal to the cash a company generates minus the amount it invests.

Company ABC is investing a lot, which is why its FCFs are negative.



How much is a lot (of capital expenditure)?

A quick way to tell how quickly a company tears through money is to compare its capital spending with its long-term assets (mostly, its plant and equipment).  

While not perfect, the comparison at least gives us an idea of how aggressively a company is spending.  

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  That's a prolific spender.

At the opposite end of the spectrum would be company like Company XYZ, which cruises along spending an amount equal to about 5% of its long-term assets.

When you see a percentage as high as 30% or 40%, chances are you're dealing with a young company just getting on its feet.

What is Free Cash Flow (FCF)?

FCF represents the cash a firm has generated for its shareholders, after paying its expenses and investing in its growth.

FCF = Total cash flow (Earnings with noncash charges added back in)  - capital spending

FCF can be very useful in assessing a company's financial health because it strips away all the accounting assumptions built into earnings.

A company's earnings maybe high and growing, but until you look at FCF, you don't know if the company's really generated money in a given year or not.

If you're an owner, FCF is ultimately what you're interested in.  FCFs represent real cash.  Earnings do not.

Free Cash Flow Return on Invested Capital

Free Cash Flow Analysis of NetFlix 

Mar 10, 2010

The following is a free cash flow analysis of NetFlix’s(NFLX) using FROIC and Price to Free Cash Flow.

FROIC for those who don’t know is = Free Cash Flow Return on Invested Capital.

Over the years I have tested out various ratios and have found very few that can compete with FROIC, in getting down to the real cash that a company is generating on Main Street .

Basically FROIC tells the investor how much free cash flow is actually generated as a percentage of the total capital that the company employs. To put it more simply, “How much free cash flow is generated for every $1 of capital that a company employs”

How does one calculate FROIC?

FROIC = Free Cash Flow/Total Capital

The way to determine Free Cash Flow is by taking a company's “Cash from Operations” and subtracting its “Capital expenditures” from it.

So in Netflix’s case its 2009 “Cash from Operations” was $325.1 million while its capital expenditures were only $45.9 million. Thus when we subtract $45.1 from $325.1 we get $280 million in free cash flow. We next take the company's $280 in free cash flow and divide it by its 58.416 million diluted shares outstanding and we get $4.79 a share in free cash flow.

If we then divide that number into the closing price of March 9, 2010 of $69.94, ($69.94/$4.79) we get a price to free cash flow of 14.6.

A price to free cash flow result of 14.6 is very attractive and I proved that in doing a backtest on price to free cash flow in the investment process”, using the DJIA 30 stocks from 1950-2007, and found that by only buying stocks that were selling for 15 times their price to free cash flow or less one would have substantially beat the DJIA 30 by a very large margin compared to buying the entire Index.

Now that we have seen what the free cash flow is for Netflix, let us now go and determine what its total capital employed is.

Basically Total Capital = Long Term Debt + Shareholders Equity

Taking just basic Total Capital is too easy in my view and I prefer is make it a little more difficult for a company to pass this test and add “other long term debt” to the equation. So for NetFlix we have the following for the year 2009.

Long Term Debt = $200 million

Other Long Term Debt = $54.2 million

Shareholders Equity = $199 million

When you add all those together you get $453.20 million for total capital employed.

Having done that we can now calculate FROIC as $280/$453.2 million or 61.78%.

What does this 61.78% mean?

For every $1 of total capital employed, NetFlix generates 62 cents in free cash flow.

I welcome everyone to go and try out FROIC on your own. In the end you will find that there are very few companies whose stock price trades for less than 15 times their free cash flow and generates 61.785 cents in free cash flow for every dollar of capital employed.


http://seekingalpha.com/instablog/498843-peter-mycroft-psaras/58154-free-cash-flow-analysis-of-netflix

POS Malaysia generates strong Free Cash Flow.

Have taken a brief look at POS.

1.  Cash rich company.  Cash RM 398.033 m, little debt.

2.  Net CFO is strong .. RM 198.451m

3.  Its FCF is strong ... net CFO 198.451 - capex 64.898 = RM 133.553m

4.  Market cap = RM 1670.2 m @ share price of RM 3.11 each.

5.  FCF/Market cap = 8% (very good).

6.  Dividend paid 50.346 m  DY = 50.346/1670.2 = 3%


It is no wonder that so many suitors are lining to acquire this stock from Khazanah.

Latest valuation based on closing price of 7.4.2011

Outstanding shares of POS = 537.03 million.

At the closing price of  MR 3.74 per share on 7.4.2011, its market cap = MR 2,008.5 million.

The FCF generated by POS in the last FY was MR 133.553 million.

Its FCF/Market Cap on 7.4.2011 = 6.65%.

Its Market Cap/FCF = 15 x

The successful company that acquire POS would have bought a company that is generating good net CFO and strong FCF.  

It is on the basis of this FCF that makes the valuation of POS seems reasonable for the moment.

Free Cash Flow - FCF

What Does Free Cash Flow - FCF Mean?
A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as:




It can also be calculated by taking operating cash flow and subtracting capital expenditures.

Investopedia explains Free Cash Flow - FCF
Some believe that Wall Street focuses myopically on earnings while ignoring the "real" cash that a firm generates. Earnings can often be clouded by accounting gimmicks, but it's tougher to fake cash flow. For this reason, some investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits).

It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.

Related Terms

• Capital Expenditure
• Free Cash Flow For The Firm
• Free Cash Flow Per Share
• Free Cash Flow To Sales
• Free Cash Flow Yield
• Indirect Method
• Operating Cash Flow - OCF
• Price to Free Cash Flow
• Shareholder Value
• Target Cash Balance
• More Related Terms

 

Related Links:

• Free Cash Flow: Free, But Not Always Easy - Free cash flow is a great gauge of corporate health, but it's not immune to accounting trickery.
• Taking Stock Of Discounted Cash Flow - Learn how and why investors are using cash flow-based analysis to make judgments about company performance.
• Free Cash Flow Yield: The Best Fundamental Indicator - Cash in the bank is what every company strives to achieve. Find out how to determine how much a company is generating and keeping.
• Where Top Down Meets Bottoms Up - Find the investing "sweet spot" by combining these two styles.
• Top 3 DCF Analysis Pitfalls - This method can be difficult to apply to real-life valuations.
• Investment Valuation Ratios: Price/Book Value Ratio - This ratio indicates, how much shareholders are paying for the company''s net assets. See this section for an indepth look at this ratio and its calculation.
• Analyze Cash Flow The Easy Way - Find out how a company spends its money and whether there will be any left over for investors.
• Using DCF In Biotech Valuation - Valuing firms in this sector can seem like a black art, but there is a systematic way to pin a price on potential.
• Debt Ratios: Cash Flow To Debt Ratio - Cash Flow to Debt Ratio measures the company''s ability to cover debt form its yearly cash flows. See this section for a detailed explanation and calculations.
• Cash Flow Indicator Ratios: Introduction - An introduction to Cash Flow Indicator ratios.
• DCF Analysis: The Forecast Period & Forecasting Revenue Growth - Determine how far out into the future you should project cash flow.
• The Essentials Of Cash Flow - Tune out the accounting noise and see whether a company is generating the stuff it needs to sustain itself.
• Warning Signs Of A Company In Trouble - Don't let your clients go down with ship! Learn how to escape the water with these tips.
• Spotting Cash Cows - We show you why some of these companies stand apart from the herd.

http://www.investopedia.com/terms/f/freecashflow.asp

What is Free Cash Flow?

FCF, or free cash flow, is net income earned from a business venture along with any depreciation or amortization that is relevant to the company. The amount of free cash flow does allow for any changes in the amount of working capital on hand as well as any shifts in capital expenditures for the period under consideration. It is free cash flow that is used by the company to honor its obligations to stockholders and others who hold debt or equity in the corporation. While not free cash in the sense that the funds can be used for anything, the cash flow is free in that it is not required to maintain the basic production functions of the company.

Calculating this cash minus expenditures involves knowing such important line items as current depreciation on property, the value of intangible assets after allowing for amortization, any interest or investment income received, returns from the sale of stocks, and any monies collected as a result of selling property. Taking all these factors into consideration makes it possible to arrive at what is known as the headline operating profit. This figure serves as the starting point for determining the amount of FCF that is currently on hand and can be used to issue payments to stockholders and others who hold debt or equity instruments issued by the company.

Under the best circumstances, any company should have a healthy free cash flow at the end of each financial period. Not only is the flow of profits necessary to allow the company to honor all its financial obligations, it also provides the foundation for future expansion. That expansion may come in the form of improving existing facilities, developing and marketing new products, or creating new facilities in new locations. The presence of the free cash flow means the company is in a good position to grow and become even more profitable.

 

Related topics

Free Cash Flow

Free Cash Flow Calculation

Free Cash Flow Model

Calculating Free Cash Flow

Calculate Free Cash Flow

Free Cash Flow Firm

Debt Free Cash Flow

Stockholders are always happy when a company posts a positive free cash flow. The presence of a cash flow that is free and in the black rather than in the red means there will be no problems in receiving dividend payments and may possibly be an indicator that the company may find it feasible to issue additional shares in the near future. It also means the company is managing expenses in an efficient manner, which helps to maximize the chances for the stock holdings to continue to earn dividends in the future.

http://www.wisegeek.com/what-is-free-cash-flow.htm

Cash Flow Problems

http://www.2-small-business.com/blog/archives/2009/05/fivetried_and_t.shtml
So, what should you do to ensure that you maintain a good cash flow?

Value Created by Free Cash Flow

Apple has grown their free cash flow at 7112% over the last 6 years or annualized at 104%.
http://seekingalpha.com/article/177496-a-complete-look-at-apple-s-financials

MTS generated significant cash flow during the year, with free cash flow of $2.1 billion in 2008, up from $964 million in 2007. In addition, net cash flow from operations increased by 32% in the year to $4.4 billion.
http://annualreview2008.mtsgsm.com/business_review/financial_review/earnings_per_ads/


http://www.faqs.org/sec-filings/091109/TRIMAS-CORP_8-K/a09-33130_1ex99d2.htm







http://google.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHTML1?ID=5792754&SessionID=6vfWWWQXC55Y9l7

Using Free Cash Flow = Cash flows from Operating Activities + Cash flows from Investing Activities

Cash Flows

Consolidated

(millions of yen)

	2005/3	2006/3	2007/3	2008/3	2009/3	2010/3
Cash flows from operating activities	14,116	22,474	19,352	24,778	11,939	27,537
Cash flows from investing activities	-(minus)3,833	-(minus)18,845	-(minus)10,109	-(minus)19,147	-(minus)14,393	-(minus)9,949
Free cash flow *1	10,283	3,629	9,243	5,631	2,454	17,588
Cash flows from financing activities	-(minus)471	-(minus)7,471	-(minus)13,231	-(minus)8,828	11,939	-(minus)30,347
Net increase(decrease) in cash and cash equivalents	9,892	-(minus)3,186	-(minus)2,939	-(minus)2,503	5,538	-(minus)11,458
Cash and cash equivalents at beggining of period	21,787	31,679	28,702	25,763	23,261	29,202
Cash and cash equivalents at end of period	31,679	28,702	25,763	23,261	29,202	17,768

*1 Free cash flow = Cash flows from operating activities+ Cash flows from investing activities

Free Cash Flow
(Cash flows from operating activities, Cash flows from investing activities, Free cash flow)

http://www.nisshinbo.co.jp/english/ir/briefing/cf.html

http://www.smallbusinessarena.com/cash-flow-statement-cash-flow-101/

Free cash flow yield trumps dividends as a driver of returns

Managing risk: An emphasis on free cash flow and transparency

As dividend cuts make headlines, it is important to remember that dividend payouts are only the tip of the iceberg when it comes to identifying dividend-paying companies and sizing up dividend risk relative to a company’s total return3 potential. Moreover, in the current environment of rising dividend yields, it’s important to be cautious about “yield chasing”, as some of these yield premiums could be due to precipitous stock price declines instead of bona fide, sustainable growth in the underlying businesses.

Consistent dividends and dividend growth are characteristics of good businesses, but in the view of the management team of the PH&N Dividend Income Fund, other more important factors must be evaluated in tandem. These include strong free cash flow, a solid financial position, and a management team with a record of making intelligent decisions regarding how it deploys free cash.

In an era when corporate earnings can easily be obfuscated by the rotating door of GAAP methodologies4, it is refreshing to be able to rely on a valuation metric that is difficult to manipulate or misrepresent. Free cash flow is one such measure, and it is attractive for its transparency.

Free cash flow is the cash that is left over after a company has made the appropriate allocations to maintain or grow its asset base (working capital and capital expenditures). Essentially, this pool of “free cash” allows a company to pursue shareholder-friendly activities, such as paying dividends, making acquisitions, and paying down outstanding debt.

The chart below was adapted from research conducted by Empirical Research Partners – it depicts relative returns for U.S. large cap stocks sorted by dividend growth, share repurchases, and price/free cash flow over the 35-year period from 1970-2005.



You will notice the following:

• Strategies focused only on dividend growth have only modestly outperformed the S&P 500 Index.
• Companies that pay no dividends at all have the worst return records.
• Strategies focused on price/free cash flow were the most effective at outperforming the S&P 500 Index.

Even in today’s severely compromised market environment, companies are fiercely protective of their free cash flow. Despite the downturn, free cash flow has held up remarkably well due to a couple of factors: a low capital expenditure base and aggressive management of working capital.

https://www.phn.com/Default.aspx?tabid=1103

Cash Flow Computation

Cash Flow Computation
The total cash flow for a period can be computed as:


Income from Operations (*see below)
+ Depreciation
- Taxes
- Capital Spending
- Increase in Working Capital
------------------------------
Total (Free) Cash Flow


Explanation:

Income from operations equals revenue minus costs and expenses and is the major source of cash.  

However, two adjustments must be made to get to actual cash inflow:

• Income from operations is before taxes are deducted, so taxes need to be subtracted here to get a corrected cash flow,
• Also, depreciation charges are included in income from operations but do not lower cash in the period, so depreciation is added back to get a corrected cash flow.

Finally, only changes (up or down) to the components of working capital (inventory, receivables, payables, etc.) in the period are part of computing cash flow.  If working capital has increased, cash is required this will need to be subtracted from total cash flow.

(Additional note:  The total cash flows used in an NPV (net present value) analysis should come from well-prepared proforma financial statements developed for the project.  The total project cash flows for a period can be computed as above.)

----

Income Statement

for the period x through y

Net Sales

- Cost of Goods Sold

-------------------------

Gross Profit

Sales & Marketing

Research & Development

General & Administrative

--------------------------

Operating Expenses

Gross Profit

- Operating Expenses

-------------------------

Income from Operations*

+ Net Interest income

- Income taxes

-------------------------

Net Income

What management does with cash flow is key to long term performance.

Cash Deployment – After playing the stock-picking game for a while I notice that what management does with cash flow is key to long term performance. Sometimes they can't think of anything better to do than to load up with debt and then go on to spend the proceeds buying back shares at inflated prices. Of course when trouble hits it becomes necessary to raise capital by selling shares at fire sale prices. Readers who have avoided these types of problem during the downturn have done better than I and deserve to be congratulated.

Mr. Market does not like capex. It's a real turnoff, peeing away money that could support a nice special dividend or be used to pump up share prices. Actually risking it in an effort to make money from expanded or more efficient operations is less attractive than the alternatives, in terms of immediate price action.

http://seekingalpha.com/article/184987-why-i-m-staying-with-verizon

Reviewing the rise in KLCI from March 09 to now

The market turned in March 09.  Those who continued to hold their stocks during the downturn would have seen substantial rebound in the prices of their stocks.  Remarkably many good stocks have risen above their previous highs.

The initial rise in the prices of these stocks was due to the steep bargain offered by the knocked-down prices created during the severe downturn.  Soon this steep bargain was eroded and most of the stocks were trading close to their fair price.  The market has the tendency to over-react on the downside and the upside.  As was mentioned before, this has something to do with the inexact science of finding the intrinsic value of a particular stock.  Moreover, there are many participants in the market who felt this is not important, driven mainly in their "trade" or "investing" by studying the sentiment driving the buying and selling of a particular stock.

What can we recollect from March 09 to now in KLSE?  The initial price rise from March 09 was broad base.  Almost all counters went up.  Few were laggards.  Soon the initial rise flattened.  The blue chips however continued to performed well.  The index linked counters continued their steady rise over the last few months, probably supported by huge institutional investors initially.  The financial counters moved steadily and swiftly, followed by others blue chips and KLCI component stocks.  The other stocks did not move much, though there were much excitement in some individual stocks like Mamee, Daibochi, HaiO and others. 

As usual, the retail investors were slow to enter the market missing the steepest part of the market rise.  It should be of interest to know the percentage of previous retail investors who are now permanently out of the stock market following the calamity in the market in 2008.  But the market is always a huge magnet.  When the market rises, new players (and also suckers) are attracted in.  The market has paused on a few occasions over the last 9 months.  The correction was not painful, the worst was a 6 percentage dip in the index over a brief period so far. 

As to whether the market price presently reflects the fundamentals, there are as many who argue either ways.  Is the market undervalued at present price?  Is the market overvalued at present price levels?  Is the market reflecting the fundamentals of the economy?  Is the market price ahead of the economy, not supported by the underlying fundamentals?  One way to get out of this confusion is to realise that in investing, you are investing into stocks and not into the market.  Therefore, for those stock pickers, the importance is in understanding the business of the company, the quality of its management and being able to place a value on the price of the business of this company. 

Since the start of market trading this new year, the market has risen upwards extremely fast indeed.  Many would have seen significant gains in their portfolio.  Many stocks have reached their 52 weeks high and there are also many that reach their all time high prices.  The prices of various stocks climbed not by mini-steps but by giant steps. Interestingly, a piece of good news can push up a stock price by a large amount. The present play is in the glove counters. This sector has proven to be resilient and growing.  Can one truly believe that the business fundamentals of a stock has increased 2 or 3 folds over this short period as would have to be accounted for by such rising prices in the stock?  As with all things too good to be true, be prepared now for when the music stops.  This is particularly most relevant for those who are late or recent comers to this wonderful bull party in the stock market.

Among my favourite stock picking matrix:  Search for those companies with 5 or 10 years consistent records of :

• high ROE of  >15% and
• generating large FCF (FCF/Sales >5%, high FCF/TOCE of >10%) 

This matrix has turned up many big winners with long sustainable economic moats for long term investing consistently.  Keep track of these companies and buy them when they are offered at fair or bargain prices. 

At bargain prices,

• the EYs (EPS/Price) and DYs are at the higher of their usual historical ranges,.and
• the FCF/EV yields  are attractive multiples of the risk free interest rates offered by fixed deposits.

[where,
FCF = Free Cash Flow = Cash Flow from Operation - Cash Flow from Investing = (CFO - CFI)
TOCE = Total Capital Employed = (Equity + LT Debt)
EV = Enterprise Value = (Market Cap + ST Debt + LTL Debt - Cash)]


http://www.investopedia.com/articles/stocks/05/cashcow.asp

Looking for the firm with an economic moat (Evaluating Profitability)

The first thing we need to do is look for hard evidence that a firm has an economic moat by examining its financial results. (Figuring out whether a company might have a moat in the FUTURE is much tougher.)

What we are looking for are firms that can earn profits (ROIC) in excess of their cost of capital (WACC) - companies that can generate substantial cash relative to the amount of investments they make.

Use the metrics in the following questions to evaluate profitability:

1. Does the firm generate free cash flow? If so, how much?
Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

FCF Margin:  Divide FCF by sales (or revenues). This tells what proportion of each dollar in revenue the firm is able to convert into excess profits.

If a firm's FCF/Sales is around 5% or better, you've found a cash machine.

Strong FCF is an excellent sign that a firm has an economic moat.

(FCF/Total Capital Employed or FCF/Enterprice Value are some measures.)


2. What are the firm's net margins?
Net margins look at probability from another angle.

Net margin = net income/ Sales

It tells how much profits the firm generates per dollar of sales.

In general, firms that can post net margins above 15% are doing something right.

3. What are the returns on equity?
ROE = net income/shareholders' equity
It measures profits per dollar of the capital shareholders have invested in a company.

Although ROE does have some flaws -it still works well as one tool for assessing overall profitability.

As a rule of thumb, firms that are able to consistently post ROEs above 15% are generating solid returns on shareholders' money, which means they're likely to have economic moats.

4. What are returns on assets?
ROA = (net income + Aftertax Interest Expense )/ firm's average assets
It measures how efficient a firm is at translating its assets into profits.

Use 6% to 7% as a rough benchmark - if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

The company's aftertax interest expense is added back to net income in the calculation.  Why is that?  ROA measures the profitability a company achieves on all of its assets, regardless if they are financed by equity holders or debtholders; therefore, we add back in what the debtholders are charging the company to borrow money.


Study these metrics over 5 or 10 years

When looking at all four of these metrics, look at more than just one year.

A firm that has consistently cranked out solid ROEs, ROA, good FCF, and decent net margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results.

Five years is the absolute minimum time period for evaluation, 10 years is even better, if you can.


Consistency is Important

Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time - not just for a year or two - that really makes a firm valuable.



These benchmarks are rules of thumb, not hard-and-fast cut-offs.

Comparing firms with industry averages is always a good idea, as is examining the trend in profitability metrics - are they getting higher or lower?

There is a more sophisticated way of measuring a firm's profitability that involves calculating return on invested capital (ROIC), estimating a weighted average cost of capital (WACC), and then looking at the difference between the two.

Using a combination of FCF, ROE, ROE and net margins will steer you in the right direction.


Additional notes:

DuPont Equation

ROA = Net Profits / Average Assets
ROA = Asset Turnover x Net Profit Margin

ROA
= (Sales/Average Assets) x (Net Profits/Sales)
= Net Profits/Average Assets

ROE = Net Profits / Average Shareholder's Equity
ROE = Asset Turnover x Net Profit Margin x Asset/Equity Ratio*

ROE
= (Sales/Average Assets) x (Net Profits/Sales) x (Average Assets/Average Equity)
= Net Profits./ Average Equity

*Asset/Equity Ratio = Leverage