BULLS & BEARS: Analyzing ‘free cash flow’ key to valuing businesses

Companies report their earnings as net income, a figure calculated according to generally accepted accounting principles, or GAAP. But that number often provides the investor with a distorted picture of what really took place. Net income often includes various non-cash items that obscure the actual cash flows within the company.

Because of this problem with reported earnings, analysts often turn to a company’s “statement of cash flows” and retrieve a figure called “cash flow from operations” or “operating cash flow.”

The calculation for operating cash flow begins with net income, then adds back depreciation along with changes in working capital that add or subtract from the cash flow of the business. Additionally, a variety of other items that affect cash may be included, such as any gains or losses from the sale of a subsidiary.

The idea is that cash flow from operations is more representative of the cash generated by the business during the reporting period and, hence, the actual earnings that accrue to the shareholders who own the business.

Financial organizations that are in the business of leveraged buyouts focus intently on the cash-generating ability of the businesses they are interested in acquiring. This is because a large percentage of the purchase price is typically financed with junk bonds. The cash flow from the business must be substantial enough to service the high interest costs from the borrowing.

However, analysts and investors who stop with the operating-cash-flow figure are making a critical mistake. Depreciation is the annual non-cash accounting charge businesses take to reflect the decline in useful life of a company’s property, plant and equipment. And while depreciation is a noncash item, to assume it does not represent an ongoing “cost” to a business is an error.

Owners of businesses know they must make regular capital investments just to maintain their revenue and competitive position within their industry. Sometimes these capital expenditures approximate the depreciation figure while in other businesses, for example those that are asset-heavy, the necessary capital expenditures can be significantly larger.

Thus, to arrive at a figure that approximates the actual cash earnings that accrue to owners, analysts and investors should estimate and subtract the cost of expenditures necessary to maintain the business from the cash-flow-from-operations number. The resulting figure is commonly called “free cash flow.”

Free cash flow is the lifeblood of a business. It is from free, or unrestricted, cash that a business can pay dividends, repurchase stock, reinvest in the business, make acquisitions or repay debt. Free cash flow provides the fuel to grow the business.

The analysis of a company’s cash flow should be a key factor in making investment decisions.

Investors should review how well a company’s management has historically handled cash generated by the business. All too often, managers make unwise acquisitions that detract from business value, all in the name of enlarging their empire. In such instances, it would have been far more beneficial to shareholders if the money had been paid out in dividends or used to repurchase the company’s stock.