Equity valuation can be a highly polarizing subject even for investors that share similar views on specific markets and industries. The concept of valuation is simple in its premise: what is Stock X worth in the near future, and does its current price reflect that worth accurately? However, there are several accepted ways to value a business, and each brings with it its own merits.
The price-to-earnings ratio (P/E ratio for short) is perhaps the most ubiquitous of them all. In essence, the P/E ratio divides the current share price of a stock by its earnings per share to adjudicate whether a stock is overvalued or undervalued compared to industry peers. The underlying thinking behind the use of the metric is that given a company’s existing rate of earnings, the P/E ratio would illustrate how many years of cumulative earnings it would take the company to realize its market cap fully. For example, a 20x P/E ratio means that 20 years of earnings would be required for the investor to recoup their investment.
However, there are shortcomings to the P/E ratio. While it is a relatively simple calculation, a company’s net income (or ‘earnings’) can be subject to manipulation via creative accounting practices. This is where a metric that is more geared towards the company’s ability to generate and/or return cash to its investors can be more instructive about a stock’s true attractiveness.
What is Cash Flow Analysis?
The volume of cash generated by a company in each period is especially insightful when gauging the company’s financial health. At a fundamental level, the value of a company is defined as the present value of all future cash flows. Conceptually, this makes cash flow the most important indicator of a company – and not net income. Over time though, the P/E ratio has become prevalent and popular in the media largely because of its simplicity. Net income (i.e., the traditional “bottom line”) can be found by quickly scanning a P&L statement and dividing the amount by the total number of outstanding shares. On the other hand, cash flow is a slightly more manual calculation.
An accurate calculation of cash flow accounts for the cash generated by a business after adding back non-cash expenses, investing in capital expenditures, and accounting for the amount of cash tied up or unlocked through changes in working capital. This comprehensive calculation of cash flow results in a number called the ‘free cash flow.’
How is Free Cash Flow Calculated?
When companies prepare financial statements, they incur a range of non-cash expenses recorded on the income statement. The most common of these non-cash expenses is that of depreciation and amortization. While D&A is a significant number that helps to account for the wear and tear that assets go through, it is not a physical outlay of cash that companies pay to a creditor each year.
Similarly, any other non-cash items such as non-cash asset impairments or stock-based compensation taken on the income statement are also added back to net income. A non-cash asset impairment occurs when a company writes down the value of an asset due to a change in expectations about that asset’s ability to generate future cash flows.
All of these non-cash expenses are added back to net income for the period.
Next, investors would look at the level of capital expenditures conducted by the business during the year. Capital expenditures can be thought of as the purchase of new assets or other strategic investments made that are expected to help the business reap benefits for several years. Even though they are ultimately reinvested into the company’s growth, they still represent a cash outflow for the business and must be subtracted.
An added benefit of using free cash flow is that investors can evaluate the ‘capital intensity’ of the business (i.e., how much the business has to invest to spur future growth).
Lastly, free cash flow accounts for the changes in working capital experienced by a business in a year. While the definition of working capital may differ from business to business, most businesses have the following as a baseline: (i) accounts receivable, (ii) accounts payable, and (iii) inventory.
The way to think about working capital is that if it results in an increase in cash within the business, then it should be added. If it causes a reduction in cash within the business, then it should be subtracted.
Once all of the above have been calculated and verified, the last step is putting it all together:
Free Cash Flow = Net Income + Non-Cash Expenses – Capital Expenditures + Decreases (Increases) in Working Capital.
The final step is to divide the stock price by free cash flow per share (similar to how a P/E ratio is calculated).
Why is free cash flow a better indicator than earnings?
As we discussed previously, earnings are susceptible to some degree of manipulation by savvy accountants who know how to use certain reporting loopholes. Free cash flow is a much more difficult metric to alter artificially. By explicitly addressing non-cash expenses, working capital, and cash paid for business reinvestments, the free cash flow metric is a significantly more transparent indicator of how much cash the business generated for its investors over a specific period. Ultimately, that makes it a much better yardstick of valuation than net income. Key reasons for this are as below:
- Regardless of whether sales are made on cash or credit, net income will account for both. However, free cash flow will only account for revenue when the accounts receivable is converted into cash.
- Depreciation methods can be altered to report lower numbers in certain years. This artificially boosts net income. As D&A is added back in free cash flow calculations, the impact of such policy changes is mitigated in free cash flow.
- Inventory valuation methods can be changed to reduce the cost of goods sold, which increases net profit. With free cash flow, the ‘changes in working capital’ component of the equation (which includes inventory) once again mitigates the impacts of such methodology changes.
- Capital expenditure is not directly tied to the income statement in the year it is incurred. That means that net profit does not account for reinvestments made in that particular year. As seen above, free cash flow specifically deducts capex as part of the calculation.
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