When hunting for winning investments, a true Fool looks at a company's level of free cash flow (FCF) to build an investment case. This is partly because, in most cases, we prefer the FCF measure to net income. It's also because we use free cash flow as a key input when doing a valuation.
If free cash flow is overstated or understated in our models, it throws the whole valuation out of whack. This applies whether we're doing a discounted cash flow analysis or a relative valuation. If FCF is misstated in doing a relative valuation, it can make a company look cheaper or more expensive than it actually is. Failure to adjust for one-time items is one way to misstate free cash flow, but there are a few other ways. Let's look at other potential problems and their solutions.
Some sources of cash are not stable or recurring
When assessing free cash flow for valuation purposes, the very first items I back out are the tax benefits from stock option exercises. Businesses reap true cash benefits from option exercises, but these benefits are dependent on the stock price and on the willingness of individuals to exercise options, not the operating performance of the business.
A current example of this is Rambus (NASDAQ:RMBS). Using the traditional definition of free cash flow (cash from operations minus capital expenditures), Rambus looks like a clear winner. It shows growth in free cash flow in each of the past three years. But when you look a little closer at the past two fiscal years, you will find that what initially looks like FCF is wiped out by removing the tax benefits the company received from options.
Buy it, don't built it
It's also important to be careful when analyzing companies that make frequent acquisitions. As a general rule, acquisitions don't count toward the measurement of free cash flow, because they tend to be large one-time items. However, there are plenty of companies out there that decide that it's cheaper to buy a business, its operations, and its customers than it is to build the business from scratch. General Electric (NYSE:GE) makes a large number of acquisitions each year; acquisitions are an integral part of the company's growth strategy.
GE has been very successful with its acquisition strategy, but companies like Blyth (NYSE:BTH) haven't been as careful. From 2002 to 2005, Blyth spent at least $51.7 million on acquisitions each year -- for a grand total of $316.2 million in the past four years. Yet Blyth's free cash flow in its most recent fiscal year was lower than it was four years ago. Now, halfway through the company's fiscal 2006 year, free cash flow has continued to drift even lower.
Blyth is the perfect example of why it's important to examine a company's acquisition strategy and to measure the performance of free cash flow two ways -- both including and excluding acquisitions. Doing this allows you to see if the company's acquisitions are increasing free cash flow or merely consuming it.
The devil is in the details
One final item comes into consideration when making comparisons between two or more companies. Take for example Motley Fool Stock Advisor pick Costco (NASDAQ:COST), which owns the majority of its warehouses and land -- and leases the rest. Competitor BJ'sWholesale Club (NYSE:BJ) does the opposite. BJ's chooses to lease the majority of its clubs, but it does own the land and buildings in some locations.
The balance sheet is the first place you'll see this difference at work. BJ's ends up with a higher proportion of obligations (the leases) that do not show up as liabilities on its balance sheet (as long as the leases are defined as operating leases). You'll also see a difference in the companies' cash flow statements. Initially, both companies will list the cost of warehouses as capital expenditures, with Costco having greater expenses here. The lease expense (rent) will be carried through the income statement and into the statement of cash flows for both companies. Over time, Costco's proportion of capital expenditures (the initial cash outlay for the warehouses) should begin to trail off, but BJ's rent expenses will continue for as long as it operates the leased warehouses.
To make an accurate comparison between BJ's and Costco, it is necessary to break down the amount of Costco's capital expenditures attributed to maintaining existing stores and opening new ones. Then do the same with BJ's. At this point it becomes possible to extrapolate the differences in the operating models of the two companies. The route that Costco takes is certainly more expensive up front, and there are cases where it could be more expensive to buy compared to renting. However, assuming the underlying economics of the clubs are strong enough, and that they have done sufficient up-front analysis on buying versus renting -- a safe assumption, I think -- buying is a strategy that should bear more fruit in the long run.
Foolish final words
If all of these adjustments sound like too much to handle, there are other methods. In our Motley Fool Hidden Gems service, a different variant of free cash flow is analyzed, which the team refers to as "owner's earnings." This measurement takes net income, then reverses any one-time items, adds back depreciation, and subtracts capital expenditures.
This method has the advantage of eliminating the need to deal with tax benefits received from stock options and other balance sheet changes from current assets and liabilities. But investors should still check to see if acquisitions are adding value, and make sure to be careful with comparisons.
On a final note, best of luck to the Red Sox this afternoon in Chicago!
Fool co-founder Tom Gardner and Bill Mann fearlessly lead the Motley Fool Hidden Gems team. To date, Hidden Gems picks have returned 28% on average, compared with 9.5% for the S&P 500. Tom and Bill are offering a30-day free trialto Hidden Gems, which includes full access to the more than 50 small-cap stock recommendations to date. Click here for more information.
Nathan Parmelee is a lifelong Red Sox fan and thinks the Red Sox will win their series in five games. He owns shares in Costco, but has no financial stake in the other companies mentioned in this article. The Motley Fool has an ironclad disclosure policy.
