As a Foolish investor, you are the captain of your own investments. So what do you look at when you're trying to value a company? You probably know that stockholders own what's left over after a company's fixed obligations (debt, etc.) have been paid. So the price of your stock can be thought of either as a multiple of this residual value (think P/E) or as the sum (in today's dollars) of these future residual amounts. But however you decide to float your valuation analysis, one thing is clear: When you buy a stock, you anchor your fortunes to a company's residual value.
People who want the quick and dirty on a company head straight for the income statement and, in the process, could be falling into accounting traps that are accepted under conventional accounting principles for earnings. So we at the Fool have long suggested that you sidestep these manipulations and go straight to the cash -- free cash flow (FCF).
But aren't there many different definitions of free cash flow, you ask? Not to worry, dear Fool. After debating long and hard, we've come up with the most accurate ways to strip down the ship on free cash flow to calculate the true value of a company.
Traditional FCF -- Setting sail with CAPEX
The most commonly used version of FCF is calculated by the formula:
Operating cash flow - capital expenditures
This is basically net income after undergoing two major tweaks: 1) Various non-cash changes in working capital items are factored out, and 2) depreciation is replaced with cash-based capital expenditures (CAPEX). Both operating cash flow and CAPEX are found on the statement of cash flows, but there's still room for error if you don't know what to include. Although this quick method is acceptable under normal circumstances, a company can go through situations when its value would not be reflected accurately through traditional FCF -- especially over the course of a single year.
Figuring out what constitutes a capital expenditure is half the battle. Although, generally, CAPEX is made up of the company's investments in its plant, property, and equipment (the investments needed for the company to continue operating and growing), certain situations call for separating out maintenance CAPEX from expansion CAPEX or acquisition growth CAPEX. Maintenance CAPEX consists of the company's investments in its existing facilities and equipment. This is often the preferred figure to use for very conservative valuations that assume no growth outside of that which comes from existing capacity.
Investors making cash flow projections for a growing company will want to use the full CAPEX figures shown on the cash flow statement, which includes both maintenance CAPEX and "expansion" CAPEX. Expansion CAPEX could be considered investments in non-mandatory plant, property, and equipment aimed at driving growth. Simple enough, isn't it?
Until you consider acquisitions.
Although acquisitions are not classified as CAPEX using traditional accounting methods, acquisitions fuel the growth of some companies and so should be considered part of operations. When a company is a serial acquirer, any acquisitions are part of the strategic operations of the business. So in that case, you should consider acquisitions as part of CAPEX.
For example, Microsoft
You can find acquisition data in the company's financial statements. If it was a cash acquisition or divestiture, it will be reported in the cash flow statement under "investing activities." However, the tricky part is estimating non-cash or partly-cash acquisitions. This requires reading the footnotes to determine the value of the acquisition or divestiture and including that in CAPEX.
Navigating choppy CAPEX
Another point that's often debated is whether to normalize CAPEX or not for valuation purposes. Capital expenditures vary throughout the years. A company like Rule Breakers pick Protein Design Labs
If you look at Protein's cash flow statement, you'll see that over the past three fiscal years, the company has increased its capital expenditures significantly but not smoothly. Although this is normal for a company in its high-growth stage, it makes valuation difficult since you'd have to extrapolate these volatile free cash flows into the future. You can normalize these "lumpy" CAPEX using two methods, both of which well-respected NYU business professor Aswath Damodaran outlines in his lectures.
The first is simply to average CAPEX over a number of years. For a company like Protein Design Labs, you'd want to capture the CAPEX that the company spends on growth to predict the value of the company. You could do this by taking CAPEX from the years that would most accurately show Protein's growth and average those to get smoother CAPEX.
The second method to normalize CAPEX is by estimating the industry average for CAPEX as a percent of total revenues (or other variable that is a measure of the size of the company). The assumption here is that, excluding external circumstances, over time this ratio should regress to the industry average. Novartis AG
Free cash flow to equity -- Cash to you, Captain
Aswath Damodaran uses a variation of FCF that he calls free cash flow to equity. The formula is:
FCFE = net income - CAPEX + depreciation -/+ increases/decreases in working capital - principal payment + new debt issued.
This measures the amount of cash left for stockholders after the company has met its capital expenditure and working capital (current assets - current liabilities on the balance sheet) needs and after debt commitments are paid. You can estimate the new debt issued for the formula by getting a book debt ratio (dividing net debt issued by the total external financing). Usually, the amount of debt a company issues is "lumpy" across several years -- one year a company could issue most of its debt, and then it might not need to issue more to raise money for a few years. So if you estimate the amount of debt by using the book debt ratio, it normalizes these lumpy issuances into something you can compare across years and companies.
You want to use FCFE when a company has a stable debt level and does not seem overburdened with leverage. This method is especially useful if you're valuing solely the stock of a company, or when you want to estimate growth of a company.
Free cash flow to the firm -- All cash on deck!
Another usage of free cash flow is to find all the free cash flow available to the firm (FCFF). The formula for this version of FCF is:
Earnings before interest and taxes * (1 - tax rate) + depreciation - CAPEX -/+ increases/decreases in working capital
This formula backs out interest expense, which would otherwise be included (as a reduction to FCF) in the most common definition of FCF.
FCFF is a way to find the amount of value available to all stakeholders (lenders, stockholders, and preferred stockholders) by taking earnings before debt interest payments. You want to use this method to value a company when it has volatile debt movements over time, or if you don't have all the information you need to factor out the debt. Strategy consultants and capital structure analysts are usually more interested in this method.
For example, let's look at Stock Advisor pick Dell
One last thing of note is that in comparing a firm's enterprise value to FCF, many investors fall into the trap of using the traditional calculation of FCF (operating CF - CAPEX). However, this is logically incorrect -- including interest expense in FCF does not capture the total value of the firm. So you end up comparing enterprise value, which is a firmwide calculation, to a FCF that is only to equity holders. Using the FCFF method, we can determine a free cash flow on a firmwide basis, which is an apples-to-apples comparison to enterprise value.
FCF all around -- Other ways to set sail
There are indeed several other methods of calculating FCF. I'm sure many of you, especially subscribers to our Motley FoolHidden Gems service, have seen Tom Gardner's version of free cash flow that he calls "owner earnings." He gets to this by calculating
Net income + depreciation + amortization +/- one-time items - capital expenditures
This excludes any changes in working capital (current assets and current liabilities on the balance sheet) because these numbers are more easily manipulated and can vary from year to year. Although the one-time items can be confusing, having them as part of the formula allows for flexibility should anything unforeseen or extraordinary occur.
If you look at his recommendation of Blue Nile
Additionally, some people like to back out the tax benefits from stock options (usually included in the operating section of the cash flow statement). These are not technically from operating activities and do not contribute to the growth of the company.
Be Foolish -- Use FCF!
Those of us who use free cash flow as a Foolish method to evaluate a company's performance often use each of the variations above. Hopefully, the company's situation and historical reinvestment needs will steer you to whichever method is most appropriate. Just remember, when you start sailing on your investing voyage, it's always important to follow the cash trail. Fool speed ahead!
Microsoft, Protein Design Labs, Dell, and Blue Nile are all Motley Fool newsletter picks. Check them out by clicking here for a free 30-day subscription to the newsletter(s) that best suit(s) your investing style.
Shruti Basavaraj is a Motley Fool research analyst. She owns shares of Blue Nile and Microsoft. The Motley Fool has an ironclad disclosure policy.