Free Cash Flow Illusions

"Price over earnings equals P/E."

"Enterprise value over free cash flow equals EV/FCF."

There's real comfort to be had in reducing a company to an equation, in putting each multimillion-dollar corporation in its own well-defined, pre-labeled box: "undervalued," "fairly valued," "overvalued," "Sirius Satellite" (NASDAQ:SIRI).

The problem is that life isn't always that simple. Sometimes, when you look up a company's statistics on Yahoo! (NASDAQ:YHOO) Finance, the number you see on your computer screen in plain black and white was calculated based on flawed information. Maybe someone missed a special dividend that paid out most of the company's cash, resulting in an inflated enterprise value. Perhaps the company is a foreign filer; some financial websites get confused by foreign filings and, instead of generating useful information from them, generate results such as free cash flow equaling "n/a." Anyone who has ever looked up Nokia (NYSE:NOK) on Yahoo! is familiar with that problem.

Faithful Fool readers may recall a column I wrote a couple of months ago, in which I laid out seven steps for determining whether a company has the makings of a Hidden Gem. Because small-cap Hidden Gems generally have low enterprise values and lots of free cash flow, I first seek out companies with low EV/FCF ratios. Next, I compare a company's EV/FCF to its growth rate -- and insist that the EV/FCF be less than the growth rate before proceeding further.

Running investment prospects through these seven tests quickly eliminates a lot of bad investment ideas. It's important to remember, however, that even after a company passes all seven steps, your research has just begun. Digests of financial information found on third-party websites are no substitute for reading a company's SEC filings. It's not enough to just look at a company and say, "It has an EV/FCF of 10 and a growth rate of 20% a year. So this one's a 'buy.'"

I come not to praise free cash flow but to bury it
Today, I want to look at just one example of how such abbreviated research -- using stock screeners and financial information websites as the sum total of your research, rather than as merely the starting point -- can lead an investor astray. As examples, we'll look at three movie vendors whose "free cash flow" numbers as reported by Yahoo! don't necessarily reflect reality: Blockbuster (NYSE:BBI), Hollywood Entertainment (NASDAQ:HLYW), and Netflix (NASDAQ:NFLX).

At this point, a review of free cash flow is in order. The "standard" definition of free cash flow is a company's cash earned from operations (cash from ops) minus its capital expenditures (capex).

But that's just the "standard" definition. Multiple variations on the classic FCF formula exist, each aimed at getting an even truer grasp on a company's cash profitability (for example, the owner earnings (a.k.a. structural free cash flow) calculation devised by Hidden Gems creator Tom Gardner).

A blockbuster revelation
Consider this statement from video renter Blockbuster's latest earnings release -- it's so uncharacteristic for a company to speak this clearly to its investors, and so on point to the issue, that I'll quote the whole thing:

Free cash flow reflects the Company's net cash flow from operating activities less rental library purchases and capital expenditures [emphasis added]. The Company uses free cash flow, among other things, to evaluate its operating performance. Management believes free cash flow provides investors with an important perspective on the cash available for debt service, acquisitions, and shareholders after making the capital investments required to support ongoing business operations and long-term value creation. The Company believes the presentation of free cash flow is relevant and useful for investors because it allows investors to view performance in a manner similar to the method used by our management and helps improve their ability to understand the Company's operating performance. In addition, free cash flow is also a measure used by the Company's investors and analysts for purposes of valuation and comparing the operating performance of the Company to other companies in its industry.

Two things bear pointing out here. First, Blockbuster acknowledges that free cash flow is a better metric than generally accepted accounting principles (GAAP) for use in evaluating a company's real cash profitability. (Of course, you also have to recognize that Blockbuster is in part just playing to its strength when emphasizing FCF over GAAP profits.)

Second, notice that Blockbuster has modified the general definition of free cash flow as applied to its business. It calculates FCF by deducting not just capex from its cash from ops -- it also deducts the cost of films purchased to stock its rental library. Because, really, when you're in the video rental business, your film library is your primary "capital" asset. In fact, if you look at the balance sheets for the three companies we are reviewing here, you will see that Blockbuster's library makes up nearly 10% of the value of its noncurrent assets; for Hollywood, the figure is 36%; for Netflix, it's more than 50%.

That's important. And it is also something an investor would be likely to miss by accepting Yahoo!'s FCF numbers for Blockbuster or Netflix at face value (Hollywood's FCF numbers are actually accurate as reported by Yahoo!). The only way to really understand (a) that you need to deduct video library expenditures when calculating free cash flow for these companies and (b) why you need to do this is by reading through the companies' filings. There's no other way to find a statement like Blockbuster's, above.

Numerical illusions
Let's now take a look at some numbers for these three companies (note that while by rights, Wal-Mart (NYSE:WMT) should also be considered here because it is a major DVD renter, its extracurricular retailing activities make it less useful in illustrating the problem at hand).

Figures in millions of dollars from the 2003 annual reports for Blockbuster, Hollywood, and Netflix.

The line titled "'real' free cash flow" reflects what each company's free cash flow number would be if rental library purchases were counted as capex. And as you can see, whether such purchases are counted as capex has a huge effect on each company's EV/FCF valuation.

All three companies pass the 7 Steps Screen based on their low EV/FCF numbers. However, each company's EV/RFCF ratio shows that it is "really" about three times as expensive as its EV/FCF counterpart. That opens to debate both Hollywood's and Netflix's passing the 7 Steps Screen and makes both companies' ultimate passage of the screen dependent on their maintaining double-digit growth rates. Granted, both Hollywood and Netflix do pass when you factor in their growth rates that exceed (and in Netflix's case, far exceed) their EV/RFCF numbers. But it's a closer call than it appeared to be at first sight.

Unless you do the additional research, you can never be entirely certain just how close a call it is.

Having trouble keeping straight the alphabet soup of investing metrics -- EV, FCF, RFCF, SFCF, and their cousins? Subscribe to Hidden Gems, and let Tom Gardner and his team of trusty analysts work the math for you. Sign up for a free trial now, and give the service a spin on our dime.

Fool contributor Rich Smith owns shares of Nokia and Netflix but of no other company mentioned in this article. The Motley Fool is investors writing for investors.