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By ponch73
November 9, 2007

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Stuy,

Rather than simply repeat here the mechanics of the enterprise value to unlevered free cash flow calculations (which can be found in a previous post at the link at the end of this paragraph), I thought I would discuss in several, long-winded paragraphs on why I focus on free cash flow. Before I commence, here is the link as promised.

The vast majority of my life as an amateur and then professional investor was held hostage by an earnings focus in one form or another. Whether it was P/E ratios, PEG ratios, consensus earnings estimates, long-term earnings growth, or earnings season, I was basically swimming (upstream, as it turns out) in earnings.

Unfortunately, the fixation on earnings did not improve my quality of life in any way -- it did not improve my investment performance, it did not necessarily give me visibility into a company's real business model and, most troublingly, it did not effectively signal me to good and bad buying opportunities.

Throughout my investing experiences, I have consistently analyzed companies by building reasonably-detailed multi-year financial models. In a professional capacity, I was required to do this exhaustively on a quarterly basis. And, so, over the course of many chilly Boston afternoons (not necessarily a reference to the weather) spent staring at a blinking screen filled with digits, I discovered that earnings and cash flows did not always sync up well with one another.

There were several jarring instances that baptized me by fire. In 2002, a company by the name of Computer Associates (CA) with a horrible reputation amongst professional investors came under scrutiny from authorities for accounting misbehavior. And, the scrutiny was justified (the CEO and CFO both ended up being sentenced to jail sentences for backdating sales contracts to help meet quarterly targets).

In my relative inexperience, I, along with the rest of the financial establishment, decided that CA was a disaster waiting to happen. The oily senior managers were nothing short of untrustworthy. I wasted countless hours trying to piece together CA's new revenue recognition model (designed specifically to smooth the company's revenue streams for aesthetic purposes) by trudging through the company's morass of on and off-balance sheet financial reporting.

While my nose was buried in press releases and SEC filings, CA traded down from roughly $40 per share all the way to $10 per share. I was a genius and a soothsayer. The SEC, DOJ and New York Attorney General (remember him?) were all putting CA through its paces. While I was busy excoriating CA's earnings power and patting myself on the back, CA's stock tripled in the course of a year. Why? Because at $10 per share, the company was trading at an enterprise value that was 7-8x very durable annual unlevered free cash flows. At this valuation level, the market was broadcasting to the world that it thought that CA would slowly wither and die. Instead, CA's free cash flows held steady (their products were very sticky and, in some cases, the only game in town) and allowed CA to deleverage itself considerably in the months and years that followed.

Three years later, an upstart software company called Salesforce.com (CRM) went public. In a rather mundane environment (this was just slightly before the time little software companies like Google and VMWare came along), the Salesforce.com IPO was a banner event. The IPO was heavily oversubscribed, and the stock popped well above its offering price on the first day of trading.

Wedded to my earnings valuations, I thought CRM was trading at a ridiculous valuation. A month later, when CRM's stock price nearly got cut in half, I still stayed on the sidelines because the stock was expensive on an earnings basis. However, CRM used a ratable revenue recognition model. So, when the company signed a multi-million dollar deal with a customer, it recognized the associated revenues ratably over a 24-month period. This had the effect of dramatically understating profitability.

Had someone had the presence of mind to focus on Salesforce.com's cash flows, however, a very different story emerged. Cash flow investors who were paying attention got a chance to buy stock in a company growing at over a 100% clip at a cash flow valuation that implied that the company was growing slower than virtually all of its older, slower-growth counterparts (in reality, CRM had a vastly superior business model than its competitors and an amazing runway for growth). While I didn't catch CRM at its all-time lows, I managed to smarten up the next time it presented a compelling buying opportunity on a free cash flow basis.

All of this goes to say that free cash flow analysis is an excellent tool that can improve your investing results. The BMW Method can alert you to promising buying opportunities. A little thoughtful free cash flow analysis can reinforce the attractiveness of those opportunities.

When old-schoolers talk about executing a thorough discounted cash flow (DCF) analysis to get to a true intrinsic value for a stock, my eyes tend to glaze over a little bit. DCF analyses are notoriously subjective because they require several inputs that are basically wild-a$$ed guesses. So, to make things more simple for a half-wit like myself, I like to flip things around a bit. Believe it or not, once you get the hang of it, this type of analysis doesn't take more than 5 minutes (if you don't trust me, ask my good friend, adiabatic).

1. I want to simply determine, at today's stock price, what the ratio is between a company's enterprise value and its unlevered free cash flows. This is the EV/FCFu multiple

2. Enterprise value takes into account the strength or weakness of a company's balance sheet in a way that merely price or market cap do not (this may help explain why WMT or CHS is really a lot more expensive than its P/E may suggest).

3. The EV/FCFu multiple tells me what the market's expectations are for a particular company's future growth. In the case of CA in 2002 (where the multiple was under 10), the market was saying that CA's cash flows were going to atrophy. In the case of CRM in 2005, the market was saying that CRM was only going to be able to grow cash flows at a 4-5% clip in perpetuity (which pretty dramatically flew in the face of the 100%+ growth it was experiencing at a time!).

4. When you can buy a non-cyclical stock (cyclical stocks are a different story altogether because they have such pronounced peaks and valleys) at an EV/FCFu multiple that implies that a company is going to go out of business or that is several orders of magnitude away from recent, observable reality, you have tilted the odds in your favor in a meaningful way. I'd like to think this is the kind of thing that would make BMW proud or, at the very least, makes Murph's handlebar start to twitch.

Cheers and thanks again,

Vik