Much has been said in the press recently about free cash flow (FCF). Suddenly, in light of the Enron and Global Crossing bankruptcies, investors have joined in a chorus, saying FCF doesn’t lie. While I’m thrilled investors are getting back to real valuation work, isn’t the true value of any investment the sum of the present value of all future cash flows?
Not all FCF is created equal. Though harder to manipulate than other valuation metrics, various FCF definitions are freely bandied about these days. Here’s my definition, which I have used for many years. Please note that I didn’t invent this definition; from the works of giants such as Benjamin Graham, David Dodd and Warren Buffett, I took what I believe is the best way to measure the FCF of a company as an ongoing concern. This is not a theoretical academic definition of FCF. I’m not concerned about the idea that the way a company is financed shouldn’t reflect its valuation, or any discussions about tax rates. I’m simply concerned about correctly valuing a company to profit from my analysis.
The following is the best way to measure free cash flow: adjusted net income plus depreciation and amortization, minus working capital requirements and capital expenditures. Robert Hagstrom’s bestseller, The Warren Buffett Way, does an excellent job of highlighting this definition of FCF as an approach Warren Buffett calls “owner earnings.” I recommend the book as a primer on how to value businesses. With this definition, you include everything necessary for a business to maintain its operations as a going concern. It’s easy to calculate and intuitive.
Compare this measure of FCF with such widely used valuation measures as EBITDA (sometimes referred to as operating cash flow) or even cash flow from operations (taken directly from a company’s statement of cash flows). Both measures can conceal important factors investors should know when evaluating a business. Like any income statement multiple, EBITDA multiples can be useful for making quick judgments about relative valuations.
I use multiples to compare companies within the same industries. It took me a few hours on Monday to formulate my opinion that Qwest is worth about $6 per share. I used an EBITDA multiple to compare Q with Verizon and then made some adjustments. I felt confident enough in my analysis to publish it on Real money Pro. Of course, I also knew Q was mired in debt and its markets weren’t growing. So all things considered, I felt I had a good call. Compare that type of analysis with what has been going on over the past few years. Usually EBITDA gets abused because people start using it as an EPS multiple: they say if a company is growing 15% on the top line, then it should trade at 15 times (or even higher) its 12-month forward EBITDA estimates. Holy cow! I am not sure that recommendation even means anything. It is like saying xyz.com is worth 30 times page views per day.
That type of analysis will not last long and I’m not sure if it will even make you any money. Set aside the fact that EBITDA estimates are usually too aggressive and thus subject to downward revisions, examining the components of EBITDA will reveal the cash flow measure as flawed.
I’m going to use Qwest, a controversial name in telecom services, to highlight the weaknesses of EBITDA and the strengths of FCF as defined by the likes of Hagstrom/Buffett. The first half of EBITDA, earnings before interest and taxes, immediately illustrates its problems. In telecom, many companies used EBITDA ratios to raise debt. As a result, bankers loved it (probably a holdover from the leveraged buyout days of the ‘80s). As debt piled up, so did interest payments.
How can you analyze Q without considering its interest payments? You’re not investing in an academic hypothetical setting; you’re investing in the real world. For 2001, Q reported interest expense of $1.442 billion, or
7.3% of its total revenues for the year. When investors are aiming for net income ratios (net income/total sales) of 15% or so (higher the better, obviously), giving up 7% on the interest line is crushing. So interest payments must be included in any free cash flow calculation. I don’t want to get stuck holding equity of debt ridden companies that may need to eventually restructure debt for equity in order to keep its doors open. That would leave shareholders with loses, not gains.
Moving on to the second half of EBITDA (the DA), I have no problem adding back D&A because they don’t measure cash flows at the time. But I object to neglecting to subtract working capital requirements or future capital expenditures. You can’t add back current D&A without accepting that in the future you will have new capital expenditures – thus yielding future D&A. Indeed, the process is circular.
Companies need to spend on property, plant and equipment to maintain and grow the size of its business. As with capital expenditures, working capital requirements are generally uses of cash and shouldn’t be ignored. For 2001, I calculated Q had $1.2 billion in non-cash working capital requirements. Anytime a current asset gets increased, it is a use of cash. That means exploding inventory levels and accounts receivable force the company to use cash. Conversely, increases in current liabilities are sources of cash. If a company extends its accounts payable, it saves cash (for a while). If current liabilities decrease, they become uses of cash. Unfortunately for Q, both current assets and liabilities went in the wrong direction in 2001, yielding a use of cash of roughly $1.2 billion –- not necessarily a negative, but a use of cash. So when Qwest buys fiber inventory for the future, in a swap-like transaction to apparently goose revenues, it is hurting its working capital position and should be negatively affected for it. Otherwise, when a company takes a one-time inventory charge every few years, it has effectively manipulated its financial strength. Investors can’t have that. Besides, someone always figures it out.
Using this type of simple analysis, you can see why Qwest may now be in a dire position. According to my calculations, for 2000 and 2001 Q had FCF (as defined herein) of roughly negative $5.319 billion and negative $4.443 billion, respectively. With cash balances at the beginning of 2000 at $78 million, Q relied heavily on debt issuance during 2000 ($4.3 billion) and 2001 ($6.9 billion) to maintain operations. With the capital markets all but closed to telecom companies, the ability to raise cash is suspect. Interestingly, if investors rely on a company’s financial statements statement of cash flows, they could draw the wrong conclusions. The line cash provided by operating activities doesn’t include capital expenses, which are included in the investing activities of the statement. But if investors look closer at the cash flow statement, they can make some easy adjustments and gain some powerful insights.
Looking forward, Qwest has said it will be FCF (I am assuming this includes capital spending) positive during 2002 and that it is cutting its capital expenditures to the $4 billion level. Doing some quick calculations, I can imagine Qwest might barely reach positive FCF next year, but would caution that if EBITDA estimates get revised down during the year, my calculation quickly goes negative. Also, most of the FCF comes at the expense of aggressively cutting capex. What if $4 billion in capital expenditures is not enough to maintain and grow the business? From 1997 through 1999, BellSouth recorded on average $5.4 billion of capital expenses per year, with the lowest spent in any given year $4.8 billion. Qwest can’t starve its local loop business of capital without ramifications. Even if Q is able to turn FCF positive, what valuation should an investor award it? How can you make an educated guess as to future FCFs? I’m almost certain that the old US West operations can be FCF positive, but its huge interest expense will hang like a ton of bricks around its neck.
By examining FCF, investors could have saved a bundle with Qwest. Too many variables in the Qwest question; it just doesn’t look positive. I’m still avoiding Qwest and still wondering how so many people got sold on EBITDA.
No positions in stocks mentioned.
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