A Beacon of Light in the Murky Waters of Modern Financial Markets

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The valuation of any investment whether it’s a bond, stock or real estate begins with an assessment of the discounted cash flow that can be taken out during its remaining life. For a bond there is no subjectivity in the cash flows you’ll receive. If you own a bond with a face value of $1,000 and the coupon rate is 5% paid annually, you’ll receive $50 annually for the remaining life of the bond. Analyzing the cash flow from a stock is a completely different exercise. The complicating factor in the analysis of an equity security is that earnings do not equal cash flow due to accruals. Furthermore, cash flow can be categorized into operating, investing and financing cash flows. Valuation should be based on free cash flow which is operating cash flow less capital expenditures. Free cash flow essentially measures the amount of cash available to equity holders after taking into account new capital investment needed for growth. Both investing and financing cash flow are limited. Cash flow from investing is the equivalent of selling off assets. For example, if you sold your car to generate some cash it would be considered cash flow from investing on your personal cash flow statement. The only problem with this form of cash is that it runs out once you have nothing left to sell. Similarly, if a company continues to raise cash through divestment, there will come a point where there are no longer any assets to sell. From a financing cash flow standpoint there is also a limitation on both the amount of debt and equity a company can issue. The main driver of free cash flow is operating cash flow, which is the only renewable source of cash for a company. By analyzing cash flows you can get true understanding of the underlying strength or weakness of a business.  In an era of managed earnings and outright fraud, operating cash flow (properly adjusted) can serve as a beacon of light for investors navigating the murky and dangerous waters of modern financial markets.

Warren Buffett actually uses his own definition of free cash flow, which he calls owner earnings to value a stock. In a prior post, I go into further detail about the definition of owner earnings and how it’s calculated. Sustainable operating cash flow tells us whether or not a business can survive on its operations alone. As any business owner will tell you, if a business is not generating enough cash flow, alternative sources of funding need to be found. Typically, there are two main ways to generate additional cash which are selling assets or raising capital in the form of stock or debt. Businesses that don’t generate enough positive cash flow will eventually go bankrupt, resulting in total losses for equity holders. Thus, the main focus of any stock investor is to determine the amount of sustainable operating earnings a company is producing. On a more personal level, earnings for a company is the equivalent of the income you report on your tax forms. However, the amount you spend on your credit card, shopping, eating out and anything else doesn’t show up anywhere on your tax forms. Thus, you could be cash flow negative by spending more than you earn but be making $1 mn a year. In a business, earnings follow cash. By focusing on cash flow investors have a much better chance of avoiding fraudulent companies. For example, the marked deterioration in Enron’s free cash flow ahead of its 2001 bankruptcy was a clear warning signal that everything wasn’t alright with the company. As the table below shows, Enron reported positive operating cash flow from 1997 to 2000. However, the massively negative free cash flow was a major red flag that something wasn’t quite right.

Enron Free Cash Flow (1997-2000)

1997

1998

1999

2000

$ millions
Cash Flow from Operations

211

1,640

1,228

4,779

Less: Cash flow from Investments

(2,146)

(3,965)

(3,507)

(4,264)

Free Cash Flow

(1,935)

(2,325)

(2,279)

515

Due to the company producing consistently negative cash flow, Enron continually attempted to raise capital through both equity and debt issuance. Eventually the company collapsed in 2001 when it lost access to the capital markets. Thus, you should always focus on sustainable operating earnings as the only source of cash that is replenishable. At the same time, a business can’t maintain its current revenue or grow without continued capital expenditures. Warren Buffett’s owner earnings is based on operating earnings but also takes into account continued capital expenditure expense. By focusing on free cash flow and Warren Buffett’s owner earnings  not only can we identify attractive businesses but also avoid fraudulent companies.

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