Have an obsession for cash flow conversion. What is the free cash flow of the company?

Charlie Munger:  If you take a business that is a GOOD business but not a fabulous (GREAT) business, they tend to fall into TWO categories:

One is the business where the whole reported profit just sits there in surplus cash at the end of the year and you can take it out of the business and the business will do just as well without it, as it would if it stayed in the business

The second business is one that reports the 12% (return) on capital but there's never any cash.  (This) reminds me of the used construction equipment business of my old friend John Anderson and he used to say in my business every year you make a profit and there it is, sitting in the yard.   There are awful of businesses like that where just to keep going (and) to stay in place, there is never any cash.  Now that business doesn't enable headquarters to drag out a lot of cash and invest it elsewhere.  We hate that kind of a business.  Don't you think that is a fair statement?

Warren Buffett:   Yeah, that is a fair statement.

https://www.facebook.com/reel/507646045755285

Summary:

2 types of Good Businesses:

One that generates a lot of free cash flows; you can take this cash out of the business and the business will just do as well without it.

One that generates little or no free cash flows, as it requires a lot of working capital or capex to maintain and sustain its business.

Manipulation of free cash flow. NOT all FCF should be valued the same.

Because investors have become suspicious of company profits, free cash flow is a popular way to assess a share.  

Rightly, profits are too easy to manipulate.  Yet, free cash flow can be manipulated as well and you need to know how to spot this.

Companies can boost their free cash flow in many ways.  

Here are a few ways they can do this:

1.  Delay paying their bills until after the end of the financial year. 

This increases their trade creditors and boosts operating cash flow and free cash flow for the year.

2.  Sell debtors to a credit company (also known as debt factoring).   

This allows a company which sells products on credit to turn those sales into cash faster than ight have been the case.

3.  Cut back on investment.  

Slashing investment in new assets can boost free cash flow, but might harm the long-term prospects of the business.

4.  Buy businesses rather than invest in new assets.   

A standard calculation of free cash flow might ignore this.

Review FCF and its trend over at least 5 years

This is why you should review a company's free cash flow over a number of years (at least 5 years) and look at the trend.  

You need to look at what is causing the free cash flow to change, as not all free cash flow should be valued the same.

NOT all FCF should be valued the same.

1.  Highest quality of free cash flow

Ideally, a company should be generating more free cash flow because its profits are growing.  This is the highest quality of free cash flow.   

2.  Lesser quality of free cash flow

Companies that are boosting cash flows through changes in working capital (paying their bills later, collecting their debtors faster and holding less stocks of finished goods) or cutting capex might be doing the right thing, but these kind of improvements are not achievable year after year.

CAPEX: Look for companies where the capex ratio is consistently below 30%

Quality companies produce high ROCE (at least 15%) and lots of free cash flow because they don't need to spend much money on new assets in order to grow.

Capex Ratio

                              Capex ratio = capex / operating cash flow

This ratio compares the amount of cash a company ploughs back into tits business through capex to the amount of cash coming into the business - its operating cash flow.

It is very easy to calculate a capex ratio for a company, using its cash flow statement.

Low capex ratio (< 30%).

The lower this ratio, the less capital intensive a company is and the better chance it has of producing lots of free cash flow and a high ROCE. 

Look for a capex ratio of lower than 30%.

Non-financial companies with low capex ratios, generally also have very high ROCE figures as well.

High capex ratio (>30%).

Companies with high capex ratios tend to have a very low ROCE.  Generally, companies with capex ratios of 30% or more tend not to produce very high ROCE.

A high capex ratio is sometimes necessary in order to give a company the scope to grow.  This is not usually a problem, as capex will tend to fall back afterwards.  However, when the capex ratio is consistently high year after year, this is a warning sign for investors.

Shell (High capex ratio) versus Domino's (Low capex ratio) for 2006 to 2015

Company Shell consistently ploughed more than half its operating cash flow back into its business with capex for 2006 to 2015.  This consistently high capex ratio - along with volatile oil prices - meant that its free cash flow moved around all over the place in this period.

Domino's capex ratio from 2006 - 2015 were mainly below 30%, except in 2008 and 2009 when it was 45% and 60% respectively.  Domino's capex ratio has declined significantly since 2008 and 2009 (when the company was investing in new distribution centers to help grow the business).  Company Domino's capex ratio is now less than 10% and in 2015 was 8.45%.  

In the ten years to June 2016, Domino's trounced Shell as an investment.  Domino's returned nearly 660%, compared with just 63% for Shell.   The divergent share price performance of the two companies was not  a surprise given what we now know about the importance of free cash flow in quality companies.

How quality companies generate free cash flow?

Cash flow is the lifeblood of any business.

There have been numerous companies that seemed to be very profitable, but were teetering on the edge of bankruptcy because they couldn't turn their profits into cash fast enough.

Profits and cash flow are not the same thing, and it is not sufficient for a company to be profitable to make it a good investment.

After finding out that a company is profitable, is to see how good that company is at turning its profits into cash flow.

A company's future free cash flow is the ultimate determinant of how good an investment the company will be.  Cash flow is the key determinant of its share price and the size of the dividend it will pay out to shareholders - which are the two elements that comprise the total returns from owning a share.

Free cash flow to the firm (FCFF)

Cash flows from operating activities + dividends received from joint ventures - tax paid  = net cash flow from operations

Net cash flow from operations - capex = FCFF

Free cash flow for shareholders (FCF) or Free cash flow for equity (FCFE)

FCFF - net interest (interest received - interest paid) - preference share dividends - dividends to minority shareholders = FCF

How can you use free cash flow numbers to identify good companies to invest in and bad ones to stay away from? 

A company with very little debt and a tiny interest payment, virtually all of the FCFF become FCF or FCFE.  In other words, there is not much difference between FCFF and FCF or FCFE.   This is a positive sign for investors and you should look for this sort of situation in companies you are analysing.

In contrast, a company with lots of borrowings and therefore interest bills to pay, the FCFF and FCF or FCFE will be different.   The interest payment has eaten up a big chunk of the company's FCFF, leaving less FCF or FCFE for shareholders.  In general, it is a good idea to avoid companies with lots of debt.  Too much of their FCFF 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 FCFF 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.

Look for a company with vey good long-term track record of producing free cash flow for its shareholders.

Companies that produce lots of free cash flow can make excellent investments.

Cash flow strategies and profits

June 1st, 2020 / By: IFAI / Resources

By Mark E. Battersby

Cash flow is the lifeblood of every business. In fact, according to a recent U.S. Bank study, poor cash flow management causes 82 percent of U.S. business failures. Although seemingly counterintuitive, many experts advise putting cash flow management before profits.

While profits are how a fabrication business survives, a failure to manage the operation’s cash flow can mean running into problems that one profitable accounting period might not be able to offset. Another study, this one by Intuit, revealed that

• 61 percent of small businesses around the world struggle with cash flow and 
• 32 percent are unable to pay vendors, pay back pending loans, or pay themselves or their employees due to cash flow issues.

Cash flow management 101
In essence, cash flow is nothing more than the movement of money in and out of the business. 

• Cash flows into the business from sales of goods, products or services. 
• Money flows out of the business for supplies, raw materials, overhead and salaries in the normal course of business.

An adequate cash flow means a steady flow of money into the business in time to be used to pay those bills. How well the fabricating professional manages the operation’s cash flow can have a significant impact on the bottom-line profits of the business.

Often, an operation’s cash inflows will lag behind its cash outflows, which leaves the business short of money. This shortage, or cash flow gap, represents an excessive outflow of cash that may not be covered by a cash inflow for weeks, months or even years.

Properly managing the operation’s cash flow allows that cash flow gap to be narrowed or closed completely before it reaches the crisis stage. This is usually accomplished by examining the different items that affect the operation’s cash flow—and looking at the various components that directly affect cash flow. This analysis can answer important questions such as the following:

• How much cash does the business have?
• How much cash does the business need to operate and when is it needed?
• Where does the business get its cash and where does it spend it?
• How do the operation’s income and expenses affect the amount of cash needed to operate the business?

Controlling inflow
In a perfect world, there would be a cash inflow, usually from a cash sale, every time there is an outflow of cash. Unfortunately, this occurs very rarely in our imperfect business world, thus the need to manage the cash inflows and outflows of the business.

Obviously, accelerating cash inflows improves overall cash flow. After all, the quicker cash can be collected, the faster the business can spend it. Put another way, accelerating cash flow allows a business to pay its own bills and obligations on time or even earlier than required. It may also allow the business to take advantage of trade discounts offered by suppliers.



Controlling outflow
Outflows are the movement of money out of the business, usually as the result of paying expenses.

• A manufacturing business’s biggest outflow most likely involves the purchase of raw materials and other components needed for the manufacturing process. 
• If the business involves reselling goods, the largest outflow will most likely be for the purchase of inventory. 
• Purchasing fixed assets, paying back loans and paying bills are all cash outflows.

Fabricators can regain control over their operation’s finances by adopting best practices and proper tools. A good first step involves how the operation pays its bills. An important key to improving an operation’s cash flow can be as simple as delaying all outflows of cash as long as possible. Naturally, the operation must meet its outflow obligations on time, but delaying cash outflows makes it possible to maximize the benefits of each dollar in the operation’s own cash flow.

Many credit cards have a cash back bonus program. Even if the program offers only 1 percent cash back, that could equate to a sizable monthly amount for many businesses. Of course, because credit cards tend to have a higher interest rate, they should only be used if the balance can be quickly paid off in full.



Improving invoicing
Improving the invoicing process is another key step in cash flow management. A business can adopt incentive strategies to be paid faster. A business enjoying a 10 percent gross margin that offers a 2 percent rebate in exchange for early payments might not be appropriate. Giving away small extra services, on the other hand, might work. Incentives might include the following:

• Small additional services
• Discounts for early payments (balances paid before a certain date, or yearly invoice versus monthly)
• Greater flexibility (for instance, a down payment required to book a delivery date)
• Some customers are just late payers and need to be nudged. The way that dunning is handled can, however, greatly affect the collection process. Timing and the quality of message content are the two main factors in the success or failure of these prods.

How the business gets paid not only affects its profitability but also its cash flow.

• Today, paper checks remain the standard method of payment. 
• However, paper checks are slow, highly susceptible to fraud and bear “hidden costs” such as additional work and back- office processing. 
• They are also inadequate for recurring invoicing.

Something as simple as asking customers to switch to electronic funds transfer (EFT) or Automated Clearing House (ACH) payments, and providing incentives to switch, are among the steps that can ensure faster, more secure, more reliable and cheaper payments.



Improving cash flow
Profit doesn’t equate to cash flow because, as mentioned, cash flow and profit are not the same. There are many factors that make up cash flow, such as inventory, taxes, expenses, accounts payable and accounts receivable.

The proper management of cash outflows requires tracking and managing the operation’s liabilities. Managing cash outflows also means following one simple but basic rule: Pay the operation’s bills on time—but never before they are due.

Having a cash reserve can help any fabricating business survive the gaps in cash flow.

• Applying for a line of credit from the bank is one way to build that cash reserve. 
• Once a business is qualified, lenders will grant a predetermined credit limit that can be withdrawn from when needed.

Yet another option might be frugality.  Aim to keep the business lean by constantly evaluating it.

• Is the purchase of new equipment really necessary? 
• Is hiring new employees really cost-effective? 
• Weighing the pros and cons of all business needs and wants enables a business to retain cash flow and avoid unnecessary expenses.

Cash flow gaps
Remember, however, the cash flow gap in most fabrication businesses represents only an outflow of cash that might not be covered by a cash inflow for weeks, months or even years. Any business, large or small, can experience a cash flow gap—it doesn’t necessarily mean the business is in financial trouble.

In fact, some cash flow gaps are created intentionally.  That is, a fabricator will sometimes purposefully spend more cash to achieve some other financial results.  The business might, for example,

• spend extra cash to purchase additional inventory to meet seasonal needs,
• to take advantage of a quantity or 
• early payment discount, or to expand its business.

Cash flow gaps are often filled by external financing sources:

• revolving lines of credit, 
• bank loans and 
• trade credit are just a few external financing options available to most businesses.

Cash flow loans
Cash flow-based loans rely on the value of the operation’s cash flow. 

• If the operation has a strong cash flow stream, it can be used to get significant loan amounts even if there are few business assets. 
• Although cash flow loans can be expensive, they play a key role in a business that is expanding.

An advantage of cash flow loans is the repayment period.

• These loans are usually designed according to the needs of the borrower, with repayment periods often between five and seven years. 
• And, since cash flow loans are different from asset-based loans, rarely does collateral have to be put up.

Flowing cash flows
Assessing the amounts, timing and uncertainty of cash flow is the most basic objective of cash flow management.

• Positive cash flow indicates the liquid assets of a business are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses and provide a buffer against unanticipated financial challenges. 
• The impact of a negative cash flow can be profound, with many businesses operating on margins so thin that frequent lost opportunities will put them on the path to closing their doors.

Obviously, every business can improve its cash flow. Of course, for this to happen businesses need to adopt best practices in the way they invoice, follow up with customers and monitor outflow. With the help of a qualified professional, these cash flow best practices may be easier to achieve.

Mark E. Battersby writes extensively on business, financial and tax-related topics.


https://fabricarchitecturemag.com/2020/06/01/cash-flow-strategies-and-profits/

Free Cash Flow

FREE CASH FLOW

An important factor in Shareholder Value Added analysis is the free cash flow (FCF) generating capability of a company.

This is the cash flow available after allowing for capital maintenance and interest payments.  FCF is calculated as:

Operating profit

Plus depreciation

Less cash tax paid

= Cash profits

Less investment in non-current assets and investment in working capital

= Free Cash Flow

FCF is useful in providing an indication of the level of a company’s cash flow generation.  

It also measures the amount of cash potentially available to cover the financing costs of the business after all necessary investment has been made.  Can the company safely consider raising more finance or making a major capital investment?

Companies often provide figures for their FCF, but there is no standard definition of the term so be cautious in using them.

If all interest payments are deducted, the resultant “levered free cash flow” indicates the amount of cash potentially available for dividends and future growth.

It is useful to compare the growth in free cash flow with that of earnings.  If the trends are significantly different, is it possible to find the reason?

Free Cash Flow For The Firm - FCFF

What is 'Free Cash Flow For The Firm - FCFF'

Free cash flow for the firm (FCFF) is a measure of financial performance that expresses the net amount of cash that is generated for a firm after expenses, taxes and changes in net working capital and investments are deducted. FCFF is essentially a measurement of a company's profitability after all expenses and reinvestments. It's one of the many benchmarks used to compare and analyze financial health.



BREAKING DOWN 'Free Cash Flow For The Firm - FCFF'

FCFF represents the cash available to investors after a company has paid all of its costs of doing business, invests in current assets (such as inventory) and invests in long-term assets (such as equipment). FCFF includes both bondholders and stockholders when considering the money left over for investors.

The FCFF calculation is a good representation of a company's operations and its performance. FCFF takes into account all cash inflows in the form of revenues, all cash outflows in the form of ordinary expenses and all reinvested cash needed to keep the business growing. The money left over after conducting all of these operations represents a company's FCFF.



Calculating FCFF

The calculation for FCFF can take many forms, and it's important to understand each version. The most common equation is shown as:

FCFF = net income + non-cash charges + interest x (1 - tax rate) - long-term investments - investments in working capital

Other equations include:

FCFF = Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate ) - Capex

FCFF = earnings before interest and taxes x (1 - tax rate) + depreciation - long-term investments - investments in working capital

FCFF = earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate - long-term investments - investments in working capital



Benefits of Using FCFF

Free cash flow is arguably the most important financial indicator of the value of a company's stock. The value, and therefore the price, of a stock is considered to be the summation of the company's expected future cash flows.

However, stocks are not always accurately priced. Understanding a company's FCFF allows investors to test whether a stock is fairly valued. 

FCFF also represents a company's ability

• to pay out dividends, 
• conduct share repurchases or 
• pay back debt holders. 

Any investor who is looking to invest in a company's corporate bond or public equity should check its FCFF.

A positive FCFF value would indicate that the firm has cash left after expenses.

A negative value indicates that the firm has not generated enough revenue to cover its costs and investment activities.

• In that instance, an investor should dig deeper to assess why this is happening. 
• It can be a conscious decision, as in high-growth tech companies that take consistent outside investments, or it could be a signal of financial issues.

https://www.investopedia.com/terms/f/freecashflowfirm.asp




Calculating FCFF

The calculation for FCFF can take many forms, and it's important to understand each version. The most common equation is shown as:

FCFF = net income + non-cash charges + interest x (1 - tax rate) - long-term investments - investments in working capital

Other equations include:

FCFF = Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate ) - Capex

FCFF = earnings before interest and taxes x (1 - tax rate) + depreciation - long-term investments - investments in working capital

FCFF = earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate - long-term investments - investments in working capital

Rearranging the equations:

*FCFF = [net income + interest x (1 - tax rate) + non-cash charges  - investments in working capital] - long-term investments.

Other equations include:

FCFF = [Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate )] - Capex

*FCFF = [earnings before interest and taxes x (1 - tax rate) + depreciation  - investments in working capital] - long-term investments.

FCFF = [earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate  - investments in working capital] - long-term investments

EBIT x (1-tax rate) 

= PBT x(1-tax rate) + Interest x (1-tax rate) 

= Net income + Interest x (1-tax rate)

Cash Flow from Operation 

= Net income + non-cash charges - investments in working capital

Intrinsic Value - A key to value investing

https://blog.elearnmarkets.com/how-to-calculate-intrinsic-value/

There is a bit of concern regarding the calculation of intrinsic value about its subjective nature despite the huge popularity. Different people come out with different intrinsic value for the same stock. Anyways the calculation of intrinsic value helps in determining the attractiveness of a stock.

Just like Warren Buffet said that he uses the following criteria to invest in stocks-

a. Business which he understands
b. Run by competent and able management.
c. With long-term focus
d. Attractively priced

He further adds

We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action.

However, many a time when a business passes all tests, it’s better to avoid the stock if the valuations are not attractive as compared to its intrinsic value.

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.

Checking the Safety of Dividend Payments using Free Cash Flow 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 per share / dividend per share

If free cash flow is sufficient to pay dividends then the ratio will be more than 1.

It is a goo idea to compare free cash flow per share with dividends per share over a period of 10 years.



Interpreting free cash flow dividend cover

1.  A great business generates consistent and growing free cash flows.

2.  During a company's period of heavy investment, the free cash flow may not cover its dividend.

3.  Usually, this maybe for that period and its free cash flow will soon be more than sufficient to cover dividends.

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

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.

Is negative free cash flow always bad?

The best companies to buy are ones that have large and growing amounts of free cash flow.

One possible drawback of this approach:  you will ignore companies with small or even negative free cash flows because they are investing heavily in new assets to grow their future sales, profits and operating cash flows.




Should you ignore companies like this?

Ideally, you will try to find companies that don't need to spend a lot of capex to grow.

However, if you come across what appears to be a quality company that is spending a lot of money, then you need to make sure the company is getting a good return on that investment.

You need to look at the trend in ROCE at the same time as you are looking at free cash flow.

If ROCE is high and rising whilst a company is spending heavily then the company could start generating lots of free cash flow when its spending settles down - if it ever does.

The main issue is how much money the company needs to spend to maintain its assets in a steady state.

The point here is that you might be making a mistake by ignoring companies with low or negative free cash flow.

There could be a great cash flow business waiting to blossom.




Four simple rules

Four simple rules when comparing FCF per share with EPS when looking for possible investment candidates:

1.  FCFps is 80% or more of EPS = definite candidate

2.  FCFps is less than 80% of EPS and ROCE is increasing = possible candidate

3.  FCFps is less than 80% of EPS but ROCE is falling = avoid

4.  FCFps is consistently negative = avoid

The free cash flow per share figure is all-revealing:  you want to see quality companies with a consistently similar EPS and FCFps, not companies where these numbers are markedly different.

Don't use the PE ratio

The price to earnings ratio (PE) s the most commonly used valuation yardstick by investors.

It is very easy to calculate.

PE ratio = share price / earnings per share (EPS)


In simple terms, shares with high PE ratios are seen as being expensive whilst those with low ones are seen as being cheaper.

Despite its simplicity, PE ratio has many pitfalls that can give investors a misleading view of how cheap or expensive some share really are.

The PE ratio's drawbacks are all to do with the "E" or EPS, part of the calculation


1.  EPS is easy to manipulate.

Companies can boost EPS by changing accounting policies.

For example, they can extend the useful lives of fixed assets such as plant and machinery, which lowers the depreciation expense and boosts profits.

2.  EPS says nothing about the quality of profits.

It doesn't take into account whether profits have changed due to sales of existing products or services - the best source of profits growth - or whether the company has invested heavily in new assets or bought another company (acquisition).

Share buybacks boost EPS by shrinking the number of shares outstanding, even if profits are static or shrinking.  Buyback can be done when the shares are expensive.  By paying too much, a large chunk of shareholder value is destroyed; the cash spent is wasted.

3.  EPS may not resemble true cash profits.

Quite often a company's true cash profits are significantly more or less than its EPS (more often less).

4.  EPS may be based on profits that are unsustainably high or temporarily low.

This means that the PE ratio could be misleadingly low or high.  

This is a particular problem for cyclical companies.



Summary:

For the above reasons, EPS can be unreliable and you should not rely on PE alone.

Once again, PE has may pitfalls that can give investors a misleading view of how cheap or expensive some shares really are.

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

Free Cash Flow

While free cash flow doesn't receive as much publicity as earnings do, it is considered by some experts to be a better indicator of a company's bottom line. 

Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments. 

Whereas earnings reports are subject to a number of different accounting tricks which can artificially boost the bottom line, free cash flow is not. 

It is quite possible, for example, for a company to have positive earnings and negative free cash flow. 

Negative free cash flow is not necessarily an indication of a bad company, however; many young companies tend to put a lot of their cash into investments, which diminishes their free cash flow. 

But if a company is spending so much cash, you should probably be investigating 

• why it is doing so and 
• what sort of returns it is earning on its investments.

http://www.investorguide.com/article/11625/the-three-parts-of-cash-flow-statements-explained-igu/

Focus on cash flow

Investors timely earn returns based on a company's cash-generating ability.

Avoid investments that are not expected to generate adequate cash flow.

Tell tale signs of good cash generation: Dividends, Share Buybacks and Accumulation of Cash on the Balance Sheet

Economies of scale refers to a company's ability to leverage its fixed cost infrastructure across more and more clients.

The result of scale economies should be operating leverage, whereby profits are able to grow faster than sales.

The combination of operating leverage and low ongoing capital requirements suggest that the firms should have plenty of free cash to throw around.

Tell tale signs of good cash generation are dividends, share buybacks, and an accumulation of cash on the balance sheet.

Another characteristic to look for when evaluating investments is predictable sales and profits. That makes financial results more stable and predictable.

Should there be high barriers to entry into this business, the firms in this business tend to have wide, defensible moats.

When they are trading at cheap prices, they are usually worth a good look.

Super-profitable companies with too much cash pile up on the balance sheet. Be proactive.

Company ABC

It has no long-term debt.

Its current ratio is around 4; rather high for a company with no debt to worry about.

It has consistently kept around 15% of total assets in cash.

Financial Efficiency - Is the stockholders' money (capital) working in forms most suitable to their interest.

Concept of Financial Efficiency

A company's management may run the business well and yet not give the outside stockholders the right results for them, because its efficiency is confined to operations and does not extend to the best use of the capital.

The objective of efficient operation is to produce at low cost and to find the most profitable articles to sell.

Efficient finance requires that the stockholders' money be working in forms most suitable to their interest.  

This is a question in which management, as such, has little interest.


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Actually, it almost always wants as much capital from the owners as it can possibly get, in order to minimize its own financial problems.

Thus the typical management will operate with more capital than is necessary, if the stockholders permit it - which they often do.

It is not to be expected that public owners of a large business will strive as hard to get the maximum use and profit from their capital as will a young and energetic entrepreneur.

We are not offering any counsels of perfection or suggesting that stockholders should make exacting demands upon their superintendents.

We do suggest, however, that failure of the existing capital to earn enough to support its full value in the marketplace is sufficient justification for a critical spirit on the part of the stockholders.

Their inquiry should then extend to the question of whether the amount of capital used is suited to the results and to the reasonable needs of the business.


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For the controlling stockholders, the retention of excessive capital is not a detriment, especially since they have the power to draw it out when they wish.

As pointed out above, this is one of the major factors that give insiders important and unwarranted benefits over outsiders.

If the ordinary public stockholders hold a majority of the stock, they have the power - buy use of their votes - to enforce appropriate standards of capital efficiency in their own interest.

To bring this about they will need more knowledge and gumption than they now exhibit.

Where the insiders have sufficient stock to constitute effective voting control, the outside stockholders have no power even if they do have the urge to protect themselves.

To meet this fairly frequent situations there is need, we believe, for a further development of the existing body of law defining the trusteeship responsibilities of those in control of a business toward those owners who are without an effective voice in its affairs.


Benjamin Graham
The Intelligent Investor