Ultimately, the value of any asset and, therefore, the investment decisions made are based on the cash-generating capability of that asset. It is this cash-generating ability, which comes in the form of the economic profit or cash flows that an asset generates, that determines its economic or intrinsic value. More specifically, it is the free cash flows, the net cash flows of a business after factoring in the cash used to maintain and grow the business, available to equity investors that an asset produces that is of primary inter- est. Since the common stock of a business is an asset owned by investors, the same rules apply—the free cash flows generated by a business deter- mine its intrinsic value.
However, when it comes to determining the intrinsic value of a busi- ness it isn’t the cash flows of today that are of the greatest interest to in- vestors. Rather, it is the ability of the company to produce cash flows well into the future that matters most. For investing is all about the future.
What will I earn from my investment today andtomorrow? Since there are many more tomorrows, it is the economic earning power of the company in the future that concerns us most. Therefore, the free cash flows pro- duced for the projected life of the business determine its intrinsic or fair value. Given that the future cash flows matter most, there are three impor- tant factors to consider:
1. At what rate of growth will the future cash flows be produced?
2. Are the cash flows earned in the future the same as those earned today?
3. How certain are we that the company will earn the projected cash flows?
As investors, we expect growth into the future. But forecasting that fu- ture growth rate is both an art and a science. It requires both skill and judgment. It requires an understanding of the competitive factors within an industry, the competitive position of a company to successfully compete, the quality of management to produce consistent operating results, the fi- nancial strength to capitalize on opportunities as they are presented, and the ability to execute in the most effective manner. This is no small task. It is easy to say, but quite hard to do—quite hard to do consistently into the future. And it is just as hard for investors to predict, for there are many ob- stacles in the way of a company outsider (which is what an investor is) try- ing to predict what a company is capable of. Therefore, getting the growth rate of our most precious future cash flows right, or as close to right as possible, is an extremely valuable advantage.
On the second point: Clearly, cash flows earned tomorrow are not the same as cash flows earned today simply because of the time value of money and the impact of inflation. Obviously, we invest because we expect in- come today (usually in the form of dividends) and growth tomorrow (in the form of capital gains). But due to the effects of inflation, a dollar to- morrow is worth less than a dollar today. Therefore, we need to bring back or discount those potential future gains (thanks to rising cash flows) to the present-day value. We do that by discounting the future cash flows back to present value using a basic discounting formula. But what about the uncer- tainty factor? How does that come into the picture?
Last, we invest because we have a degree of confidence that the future is somewhat predictable. But somewhat predictable is not absolutely pre- dictable. There is a degree of confidence but not an absolute degree of con- fidence. All well and good, but how does an investor quantify that degree of confidence? By using the same discount tool that brings the future cash flows back to the present value.1
Well, there you have it—the essence of the intrinsic valuation model:
■ Free cash flows produced by the company today.
■ Growth of the free cash flows into tomorrow.
■ Uncertainty or risk of not generating the projected free cash flows.
■ The present value of the future cash flows.
Put another way:
■ How much profit does our investment produce today?
■ How much profit will our investment produce tomorrow?
■ How certain are we that the company will produce that profit?
■ What is the current value of the profits of the company?
Since the last two points, uncertainty and present value, are captured in the same formula, we can reduce our intrinsic value model to its three inputs:
1. Free cash flows 2. Growth 3. Risk
Let’s take each in order.
The Free Cash Flows of a Business
The value of an equity investment in a company is the funds that accrue to my ownership interest. The funds that accrue to my ownership interest can come in several forms. One popular form, for example, is that the business can pay dividends and they are the funds that are calculated as my cash flows. It is, in effect, the cash flowing from the business to investors. This is fine if the growth and return prospects of the business are less than what an investor could earn simply by taking those funds and reinvesting them in a broad market index, like the S&P 500 index.2But what if a company did have growth prospects that could produce a rate of growth and return that was greater than the stock market as a whole? Then, why would I want to receive dividends from a company that I own shares in if the company is ca- pable of using that money to generate a rate of growth and return greater than what the market has to offer and doesn’t? Think of it this way:
Dividends are a dispersal of corporate money. They are a form of cash flows to investors that can be used to calculate the intrinsic value of a com- pany. But they are also a statement about the growth and return prospects of a business. In effect, their very existence says, “Our company cannot find growth and return prospects that exceed the return you, our investor, can receive elsewhere. Therefore, here, take the money and do something more productive with it. We can’t.”
Pretty powerful stuff, wouldn’t you say? And an important point to be made about the productive use of capital—something that I will get to as follows:
If dividends are not the applicable definition of the free cash flows that accrue to me as an investor, what is? The answer lies in the phrase “grow or die.”
Ownership in stocks is all about the corporate struggle between
growth and death. Dividends are a sign that growth into the future is lim- ited. The company has more free cash flows than it has productive projects and, therefore, dispensing some of that excess cash generated to you, the investor, to do as you please with it makes more economic sense than plowing that excess cash flow into corporate investments that produce a below-market rate of return.3 Growth, on the other hand, is indicated when a company does not dispense its excess cash (its free cash flows) and instead reinvests it into the business and produces an above-market rate of return. The company could dispense that money but doesn’t. The funds that a business could dispense—its free cash flows—are the funds that could accrue to me, the equity investor. Since they are the free cash flows that could accrue to me and that I trust in the company to put those funds to good productive use, I will use that figure as my cash-generating num- ber—my free cash flows.
To recap: Dividends are cash distributed to investors and, as such, are a form of cash flows to investors that can be used in the DCF valuation model to determine the intrinsic value of the business. However, beyond the valuation formula, the larger issue at work is the statement that divi- dend distributions (and stock buybacks) are a reflection of below-market rate of return opportunities for the company and therefore must be taken into account when viewing the company as a whole—its growth prospects, its risk factors. For most investors who are more interested in the growth prospects of a business (capital gains) as opposed to the income prospects (dividends, stock buybacks), the reapplication of the excess cash flows back into the business is of greater interest. Therefore, we need to under- stand what goes into the free cash flows of the business.
Let the calculating begin.
Show Me the Real Money
There are several ways to derive the cash-generating power of a business (its free cash flows). One useful way, and the one that I prefer to use, is to start with the company’s net income and then adjust that figure for the ac- counting distortions inherent in arriving at net income. In that way, we can then reach the true cash-generating capacity of firm—its free cash flows.
The basic formula I prefer is:
Net Income + Depreciation
– Capital Expenditures (Capex) +/– Change in Working Capital
= Free Cash Flows of a Company
Net income is an excellent starting point in our search for the real money because it highlights two important points:
1. It is the conventionally acknowledged measure of corporate perfor- mance.
2. It is a distortion of the real economic profit of a business.
The first point is well known and a given. The second requires a fur- ther comment.
Net income is an accrual accounting-derived expression of the eco- nomic performance of a business—its bottom-line profit. It is the sum of money earned after all expenses have been factored in and taxes have been deducted. Unfortunately, it is a number that, in most cases, does not reflect true performance reality—the real economic profit of the business. The ex- cellent textbook The Analysis and Use of Financial Statements by White, Sondhi, and Fried states:
Accrual accounting does have its weaknesses. It is subject to per- vasive accounting assumptions such as the going concern assump- tion. Because periodic statements must be prepared, estimates of the revenues earned and costs incurred during the reporting inter- val are required. These estimates require management judgment and estimates that are subject to modification as more information about the operating cycle becomes available. Accruals are, there- fore, susceptible to manipulation by management’s choice of ac- counting policies and estimates. Furthermore, accrual accounting fails to provide adequate information about the liquidity of the firm and long-term solvency. Some of these problems can be allevi- ated by the use of the cash flow statement in conjunction with the income statement.4
As you can see, accounting rules allow corporate management a great deal of latitude. And the potential for distortion, intentional or not, exists.
The accounting rules allow corporate managements to apply the rules to their situation according to the correct application of a given rule. It also assumes that management will exercise good judgment and accurately re- flect the true financial strength of a business and its true operating capabil- ity using the accounting rules at its disposal. However, since not every corporate situation fits neatly into the existing accounting rules, problems in determining true economic profit arise. Moreover, some accounting rules, such as depreciation, are meant to provide companies with a tax benefit enabling them to properly reflect the erosion in the productive value
of fixed assets and to eventually replace those assets in the future so that a company can maintain and grow its business. The problem arises when the future plans of the business do not match up with the current-day depreci- ation write-off of the assets. Corporate circumstances can and do change.
Additionally, the cost to replace the written-off assets may not match up with the deductions taken. This is the tip of the accounting distortion ice- berg. There are other financially derived issues, too numerous to mention here5but necessary to at least appreciate.
The bottom-line point to be made here is that accounting rules can and often do distort the true economic profit of the business. The net income number is an accepted measure of corporate performance but it should not be taken as a measure of true economic performance. Accordingly, it needs to be adjusted. Therefore, the usefulness of net income lies in the fact that it is a number that should be used only as a starting point in our quest for determining the true economic profit of the business.
Back to the Formula
The free cash flows formula (net income + depreciation – capex + or – changes in working capital) is elegant and insightful in its simplicity for several reasons. First and foremost, it captures quite nicely the operating essence of the business. It is a formula that in effect describes what it takes to maintain and grow a business.
■ Depreciation, a noncash charge, is added back in to reflect the fact that no cash expense was actually made.
■ Capital expenditures (capex) are subtracted because they were the ac- tual funds dispensed for fixed assets.
■ Working capital is the shorter-term operating lifeblood of the business and is a source or use of funds, hence the plus or minus calculation.
Let’s consider several important factors in the three adjustments to net income.
Depreciation Depreciation is the accounting write-off of an earlier capital expenditure. Because depreciation is a book entry write-off of a previously acquired asset, it is not an actual expenditure. It is a noncash charge. And being a noncash deduction against revenues, depreciation ends up lowering the net income of a business. Accordingly, it should not be deducted from the current cash-generating power of the business as it was not an actual disbursement of funds and needs to be added back to net income. It, in ef- fect, is a source of funds.
Capital Expenditures (Capex) Capex, on the other hand, is an outlay of money. Capex is the investment in fixed, long-lived assets that are neces- sary for business growth and development. Capex is, therefore, considered a use of funds. Since it is an outlay of capital necessary for the growth and development of a business, it must be deducted from the free cash flows available to equity investors (that’s us).
Working Capital The textbook definition of working capital is the differ- ence between current assets and current liabilities:
Current Assets – Current Liabilities = Working Capital
The problem with this definition and its lack of usefulness for our pur- poses is that both current assets and current liabilities contain nonoperat- ing items such as cash, marketable securities, and short-term debt. Since we are interested in determining the economic profit of the business, we there- fore need to exclude those nonoperating items in the working capital equa- tion. In other words, what we are really seeking are those shorter-term operating factors that are either a source or a use of funds necessary to maintain and grow the business. In this regard, there are three components that are of use and value to understanding the source and use of funds for operating a business: accounts receivable, inventory, and accounts payable.
These three components of current assets and current liabilities are of great interest to investors, for they help us determine the free cash flows of a business.
Here are a few salient points on all three:
1. Accounts receivable are sales booked but not collected. They are the funds owed to the firm by customers that will be collected (and re- ceived as cash) in the near future.
2. Inventory is products held and ready to be sold.
3. Accounts payable are the mirror image of accounts receivable—they are a calculation of what a business owes suppliers for services or products received that it has been billed for but has not yet paid.
Each of these three components is either a source of funds or a use of funds and, as such, directly impacts the free cash flows of a business. For example, a sale that has been recorded as such but has not been collected is a use of funds (accounts receivable). Revenues have been booked but the cash from the sale has not been received. The sale shows up as an entry on the income statement and thereby inflates the net income bottom-line num- ber. Conversely, a bill that has not been paid but is recorded as an expense
is a source of funds (accounts payable). It shows up on the income state- ment as an expense and thereby reduces the net income figure. In both cases, entries have been made on the income statement (revenues and ex- penses), a portion of which (receivables and payables) did not generate an actual exchange of money.
As to inventories, the cost to produce products is an expenditure that is recorded not as a direct out-of-pocket expense in the current income statement period but via an accounting rule either on a first in, first out (FIFO) basis or on a last in, first out (LIFO) basis. Either way, the money spent to produce the inventory is not directly lined up with the charge an investor sees on the income statement.
In all three cases, what we are interested in as investors is the change year over year. It is that change, the year-over-year difference, that source or use of funds, that needs to be accounted for in our quest for the free cash flows of the business. And that change impacts the free cash flows of the business. Consider the following example regarding accounts receivable:
■ Revenues for a given year are $10 million.
■ Of that figure, $2 million was recorded as accounts receivable (funds due).
■ The difference of the accounts receivable number on the balance sheet is a $1 million increase.
■ Revenues actually received are overstated by $1 million.
“Whoa,” you might say. “Why aren’t revenues overstated by $2 mil- lion as that is the amount of money that was booked but not received?”
The reason the overstatement in revenues is $1 million and not $2 million is due to the simple fact that some of the previously recorded accounts re- ceivable have been collected in this statement period. Get it? It is the change (on the balance sheet) that we are interested in—the change from one statement period to the next that incorporates the source or use of funds. Let’s do another basic example.
Say that a company’s net income was $4 million, its depreciation was
$800,000, capital expenditures (capex) were $1.2 million, and the net change in working capital was –$400,000. We can determine our free cash flows as follows:
Net Income $4,000,000
+ Depreciation + 800,000
– Capital Expenditures (Capex) –1,200,000 +/– Change in Working Capital – 400,000
= Free Cash Flows of a Company $3,200,000