Enterprising investors seeking to profit from corporate securities must focus on a company’s ability to generate cash flow. In this essay, we discuss how Tortuga Capital defines, calculates, and analyzes corporate cash flow.
We feel that the most relevant measure of cash flow to investors is “free” cash flow. Free cash flow, as we define it, is the total cash flow available to all the firm’s capital providers after all necessary expenditures have been made to maintain the business in a steady state.
We calculate a company’s free cash flow for the preceding five years, or longer for highly cyclical companies, because we believe that understanding a company’s historical cash flow is an essential component of a sound and conservative analysis. We define free cash flow as normalized, unlevered after-tax operating earnings, plus depreciation and amortization, minus investments in net working capital and capital expenditures.
For investors who want to build a stronger foundation in financial statements, cash flow, valuation, and business analysis, the Fundamental Investing Institute offers structured investing and finance courses.
Normalized, Unlevered After-Tax Operating Earnings
We begin our calculation of free cash flow by “normalizing” the company’s income statement; that is, identifying and eliminating non-recurring gains, losses, and expenses.
We seek to identify areas of a company’s accounting that require management estimates, such as the reserve for uncollectible accounts receivable, and determine whether such estimates are comparable to those of prior periods and industry norms. We pay particular attention to whether a company is following applicable accounting guidelines for revenue and expense recognition.¹
We make these adjustments because we are interested in a company’s sustainable earnings, untainted by non-recurring events and accounting estimates.
The adjusted income statement gives us three key pieces of information that we use in calculating free cash flow: revenue, cost of goods sold, and operating expenses. The net result of these three components is a company’s operating income.²
We then multiply operating income by one minus the tax rate, or 1 – tr, which gives us the after-tax operating profit if the company had no debt. We refer to this measure as net operating profits after taxes, or NOPAT.³
Depreciation and Amortization
The next step in calculating free cash flow is to identify a company’s depreciation and amortization.
Depreciation is the periodic expensing, or writing down, of the cost of tangible assets. Amortization is the periodic expensing of certain intangible assets. Both measures require estimates of an asset’s useful life and salvage value. These measures are also non-cash accounting charges, which is why we add them back to NOPAT.
Both depreciation and amortization can be found in a company’s statement of cash flows.
Investments in Net Working Capital and Capital Expenditures
All companies must invest at least a portion of their earnings to maintain their current economic state. What most distinguishes free cash flow from accounting earnings is the estimation and subtraction from operating earnings of these investments.
A company’s net working capital is the difference between current operating assets, such as accounts receivable, inventory, and prepaid expenses, and current operating liabilities, such as accounts payable, customer deposits, and accrued liabilities. An increase in net working capital is a use of cash. As such, an increase in net working capital must be subtracted from NOPAT.
Capital expenditures represent a company’s acquisition or improvement of long-term assets, such as property, plant, and equipment. Capital expenditures take two forms: maintenance capital expenditures and growth capital expenditures.
Maintenance capital expenditures are non-discretionary. In other words, they are the expenditures necessary for a company to maintain its current capacity. Growth capital expenditures, however, are discretionary expenditures a company can make to expand its operations.
Ideally, we would use maintenance capital expenditures in calculating free cash flow. The reason is that our preferred valuation approach, capitalization of current normalized free cash flow, requires us to view a company’s cash-generating ability in a steady state. This requires us to focus on cash flow available for all discretionary uses, including growth. However, companies generally disclose only total capital expenditures, so determining the amount that is non-discretionary can be difficult.
Another complicating factor in determining capital expenditures is that companies generally make large capital investments in some years while making few capital investments in others. We generally deal with this by analyzing capital expenditures in relation to sales over several years and using an average in our free cash flow calculation.
From Free Cash Flow to Firm Valuation
Free cash flow is the well from which all investment returns flow. A company that generates free cash flow can pay dividends, repurchase shares, invest in growth, make acquisitions, or pay down debt. These uses of free cash flow can, under the right conditions, accrue value to common stockholders.
Our calculations of past free cash flow are merely one consideration in assessing future free cash flow. Once we have made the necessary calculations of a company’s historical free cash flows, we then want to know:
- How probable is it that the company can maintain or grow its current free cash flow?
- How has management used cash in the past, and how do they intend to use it in the future?
- Is management skilled at capital allocation?
In answering these questions, we consider Graham and Dodd’s statement: “Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.”⁴
In other words, assessing a company’s ability to generate future cash flows involves more than an assessment of past financial statements. A securities analyst must assess the industry, managerial ability and initiatives, competitive threats, and other factors. Once we have assessed these factors, we can then begin to calculate the value of the firm.
Discounted Cash Flow Analysis
Discounted cash flow analysis, or DCF, is our preferred method of business valuation. Under the DCF method, the value of a company is the present value of the company’s future free cash flows. This method was first popularized by economist John Burr Williams as the “rule of present worth.”⁵
We do apply, as a supplementary method, the ubiquitous “two-stage” model often found in many valuation texts, which allows us to test the impact of varying growth rates on firm value.⁶ However, our preferred method is to use a “single-stage” model.
In other words, we calculate a level of average free cash flow that we believe the company can maintain in a steady state of business. We then discount this figure by a rate of required return that reflects the respective risk and weights of the firm’s equity and debt capital, referred to as the firm’s weighted average cost of capital, or WACC.
We believe that by using a single-stage model, we can be more conservative and less reliant on estimated growth rates than would be the case under a traditional DCF model.
To calculate the value of the equity per share, we then subtract any non-equity claims, such as debt, preferred stock, outstanding employee stock options, and underfunded pensions. We then divide this amount by the number of outstanding common shares.
The per-share value is the base value against which we can compare the current market price, considering an investment only when carefully calculated value is substantially above the current price.
Free Cash Flow and Relative Valuation
Given that business valuation is more of an art than a science, it is important for a securities analyst to employ several different valuation methodologies when valuing a company and, by extension, a financial security.
In recognition of this, we employ a method referred to as comparable companies analysis to supplement the discounted cash flow method. Under the comparable companies method, a securities analyst values a company by establishing a range of multiples on various financial measures of similar companies. The analyst then chooses the most relevant multiples and applies them to the company being valued.
At Tortuga Capital, we employ the comparable companies method by calculating an enterprise value, or EV, to free cash flow multiple for both the company and its selected comparable companies.⁷ If a company seems undervalued on a DCF basis, the undervaluation can be further supported by a low EV-to-FCF multiple.
An added benefit to employing the comparable companies method is that by analyzing a company’s competitors, we can further our understanding of the company’s industry and competitive position.
Conclusion
Enterprising investors are interested in owning assets for the cash that the asset can generate over its useful life. For investors in corporate securities, the relevant cash flow is free cash flow.
Free cash flow is the cash flow available to all a company’s capital providers after all necessary expenditures have been made. An investor focusing on free cash flow can determine whether a company can adequately service existing debt, issue and service new debt, and accrue value to common stockholders. Free cash flow also allows an investor to determine the value of the company.
¹ The two most widely used global accounting standards are U.S. Generally Accepted Accounting Principles, or GAAP, and International Financial Reporting Standards, or IFRS.
² Operating income is often referred to as earnings before interest and taxes, or EBIT.
³ The relevant tax rate is the combined federal and state marginal tax rate.
⁴ Benjamin Graham and David Dodd, Security Analysis, 6th ed. (New York: McGraw-Hill, reprint 2009), 474.
⁵ John Burr Williams, The Theory of Investment Value (Cambridge: Harvard, 1938), 55.
⁶ For an overview of a multistep DCF method, see Aswath Damodaran, Damodaran on Valuation (Hoboken: Wiley, 2006).
⁷ Enterprise value = total market capitalization + net debt + preferred stock + noncontrolling interest.
