Earnings question

[SlowHabit]

I have read a few articles where "experts" advise to use free cash flow when evaluating companies because you can't manipulated it like earnings. I am confused regarding this claim.

Free cash flow is basically net income + depreciation + amortization - capital expenditures.

Earnings is net income divided by a company's outstanding share.

Since net income doesn't change in either equation, where is this "manipulation" that these experts are talking about?

PS. I understand that earnings can be manipulated by keeping certain expenses off the balance sheet. But it's not like free cash flow uses a different net income. Or the key here is that free cash flow subtracts capital expenditures? Help.

[spider]

I'm not an accountant but I think that you could find a better defn than that for FCF. At a min, you need to add proceeds from sales of plant assets (or maybe you meant net capex rather than gross?).

Anyway, it is not all about manipulation either. For example, amortization of goodwill can drive a huge wedge between earnings & cash flow. As a result, a company could amortize goodwill quite reasonably and yet as an analyst you could derive very different valuations for the company based on earnings vs FCF.

[PRE]

Net income is flawed because it is based on the accrual accounting methodology. Accountants believe that a better picture of the firm is not the actual cash coming in, but rather the actual "business" that was generated. For instance, if a manufacturer only accepts credit cards, then it's theoretically possible that the company didn't collect any cash from customers during an accounting period (the cash could be collected a few months after the accounting period ends). The problem with this, obviously, is that it's not a very good picture of how profitable the firm is. As a result, sales can be a combination of cash, accounts receivable (money you'll be soon receiving such as credit card sales), and many other things. As a result, net income is not the same thing as the actual cash received.

Although accountants prefer accrual accounting, financial analysts are more concerned about projecting future cash flow. We prefer not to project net income because it can be easily manipulated in various ways. A common saying is that income is an opinion, but cash is a fact. One obvious example is a company with a lot of account receivable on their balance sheets; who is to say that in the future the company will be able to collect 100% of these payments that are owned to them? By looking at cash each period, however, the current receivables will eventually turn into guaranteed cash that can be projected with confidence.

Free cash flow is typically what analysts like projecting in the future. This is crudely defined as cash flow from operating activities (under the cash flow statement – this is the actual cash the company brings in each quarter or year) less maintenance CAPEX (capital expenditures used to keep the business running) plus depreciation and amortization (D&A are purely accounting figures and normally don’t do a good job of representing the actual decay of goods, so we just like to ignore it). You states that free cash flow is “net income + depreciation + amortization - capital expenditures.” This is not true; it is cash flow from operations + depreciation + amortization - capital expenditures. As I stated earlier, cash flow from operations is the actual cash brought in. You are correct in realizing the definition you had makes no sense. Cash flow from operations is an adjustment of net income to eliminate the flaws associated with accrual accounting; this is done by adjusting net income for the working capital accounts (accounts receivable, inventory, accounts payable, etc.). I don’t want to complicate things more by explaining in this post how to go about doing this, but if you’re interested you can easily find many sources explaining it.

Remember, though, that free cash flow can also be manipulated (don’t accept cash flow from operations as always being correct). Companies will try manipulating anything and they can also manipulate cash. For instance, say a company realizes it will have a negative cash flow from operations for an upcoming quarter. To raise more cash, it can sell off its account receivables (money it would receive later on) at a discount. Although it will be able to keep a healthy cash flow for the upcoming quarter, it’s obviously hurting itself in the long run taking in less cash than the original account receivables were worth.

Hope this didn’t complicate things more for you.

[krishan]

cash versus earnings is one of the fundamental questions in fundamental stock analysis. The idea behind cash is some companies have large non-cash expenses like stock comp, depreciation and amort. D&A is meant to spread the cost of large capital expenses over the period within which the equipment is used. Sometimes the equipment being depreciated doesn't really lose value. So in that particular case the depreciation is somewhat of a ghost charge and looking at cash earnings instead of GAAP earnings makes more sense. There are situations where the reverse is true and an item really does need to be replaced at the end of it's depreciation schedule. In these spots it makes sense to use GAAP instead of cash. For example, a company buys a widget for 10M and depreciates it for 10 years at which point it's replaced. Each year they incur 1M of depreciation and 0 capex. If you are a cash guy you will overestimate the value of the company as D&A are not ghost charges. They really are part of the cost of doing business.

DSUP is a good example of a company with some large D&A on items that don't really depreciate in value. The forming/shoring equipment they rent out has a fair high amount of depreciation. But the equipment last far longer than the depreciation schedule suggests. Also they are generally able to sell equipment at retail prices even if it is years old which is why they generate such amazing margins on the sale of rental equipment.

My boss strictly a cash guy and there are times where I really hate it because the non-cash charges are real or a large part of the cash benefits are due to working capital improvements (not sustainable). If you are strictly a cash guy some companies will look better than they should and some will look worse. The same is true if you are a GAAP person.

SM taught me that the goal is to find the appropriate valuation metric for the company. Figure out if it makes sense to look at them from a cash perspective or not. I think that's the best way to go.

Krishan

[PRE]

[ QUOTE ]
I'm not an accountant but I think that you could find a better defn than that for FCF. At a min, you need to add proceeds from sales of plant assets (or maybe you meant net capex rather than gross?).

Anyway, it is not all about manipulation either. For example, amortization of goodwill can drive a huge wedge between earnings & cash flow. As a result, a company could amortize goodwill quite reasonably and yet as an analyst you could derive very different valuations for the company based on earnings vs FCF.

[/ QUOTE ]

Companies are no longer allowed to amortize goodwill. It can only be impaired.

[krishan]

[ QUOTE ]
Net income is flawed because it is based on the accrual accounting methodology. Accountants believe that a better picture of the firm is not the actual cash coming in, but rather the actual "business" that was generated. For instance, if a manufacturer only accepts credit cards, then it's theoretically possible that the company didn't collect any cash from customers during an accounting period (the cash could be collected a few months after the accounting period ends). The problem with this, obviously, is that it's not a very good picture of how profitable the firm is. As a result, sales can be a combination of cash, accounts receivable (money you'll be soon receiving such as credit card sales), and many other things. As a result, net income is not the same thing as the actual cash received.

Although accountants prefer accrual accounting, financial analysts are more concerned about projecting future cash flow. We prefer not to project net income because it can be easily manipulated in various ways. A common saying is that income is an opinion, but cash is a fact. One obvious example is a company with a lot of account receivable on their balance sheets; who is to say that in the future the company will be able to collect 100% of these payments that are owned to them? By looking at cash each period, however, the current receivables will eventually turn into guaranteed cash that can be projected with confidence.

Free cash flow is typically what analysts like projecting in the future. This is crudely defined as cash flow from operating activities (under the cash flow statement – this is the actual cash the company brings in each quarter or year) less maintenance CAPEX (capital expenditures used to keep the business running & growing) plus depreciation and amortization (D&A are purely accounting figures and normally don’t do a good job of representing the actual decay of goods, so we just like to ignore it). You states that free cash flow is “net income + depreciation + amortization - capital expenditures.” This is not true; it is cash flow from operations + depreciation + amortization - capital expenditures. As I stated earlier, cash flow from operations is the actual cash brought in. You are correct in realizing the definition you had makes no sense. Cash flow from operations is an adjustment of net income to eliminate the flaws associated with accrual accounting; this is done by adjusting net income for the working capital accounts (accounts receivable, inventory, accounts payable, etc.). I don’t want to complicate things more by explaining in this post how to go about doing this, but if you’re interested you can easily find many sources explaining it.

Remember, though, that free cash flow can also be manipulated (don’t accept cash flow from operations as always being correct). Companies will try manipulating anything and they can also manipulate cash. For instance, say a company realizes it will have a negative cash flow from operations for an upcoming quarter. To raise more cash, it can sell off its account receivables (money it would receive later on) at a discount. Although it will be able to keep a healthy cash flow for the upcoming quarter, it’s obviously hurting itself in the long run taking in less cash than the original account receivables were worth.

Hope this didn’t complicate things more for you.

[/ QUOTE ]

I disagree with most of the opinions here. The technical stuff is all right. I'm a GAAP guy in general.

Krishan

[krishan]

One simple thing that SM always ask for when we look at a company is the D&A - capex spread. Generally if a company has higher D&A than capex you can consider the difference additional profit. Generally...

Krishan

[PRE]

[ QUOTE ]
[ QUOTE ]
Net income is flawed because it is based on the accrual accounting methodology. Accountants believe that a better picture of the firm is not the actual cash coming in, but rather the actual "business" that was generated. For instance, if a manufacturer only accepts credit cards, then it's theoretically possible that the company didn't collect any cash from customers during an accounting period (the cash could be collected a few months after the accounting period ends). The problem with this, obviously, is that it's not a very good picture of how profitable the firm is. As a result, sales can be a combination of cash, accounts receivable (money you'll be soon receiving such as credit card sales), and many other things. As a result, net income is not the same thing as the actual cash received.

Although accountants prefer accrual accounting, financial analysts are more concerned about projecting future cash flow. We prefer not to project net income because it can be easily manipulated in various ways. A common saying is that income is an opinion, but cash is a fact. One obvious example is a company with a lot of account receivable on their balance sheets; who is to say that in the future the company will be able to collect 100% of these payments that are owned to them? By looking at cash each period, however, the current receivables will eventually turn into guaranteed cash that can be projected with confidence.

Free cash flow is typically what analysts like projecting in the future. This is crudely defined as cash flow from operating activities (under the cash flow statement – this is the actual cash the company brings in each quarter or year) less maintenance CAPEX (capital expenditures used to keep the business running & growing) plus depreciation and amortization (D&A are purely accounting figures and normally don’t do a good job of representing the actual decay of goods, so we just like to ignore it). You states that free cash flow is “net income + depreciation + amortization - capital expenditures.” This is not true; it is cash flow from operations + depreciation + amortization - capital expenditures. As I stated earlier, cash flow from operations is the actual cash brought in. You are correct in realizing the definition you had makes no sense. Cash flow from operations is an adjustment of net income to eliminate the flaws associated with accrual accounting; this is done by adjusting net income for the working capital accounts (accounts receivable, inventory, accounts payable, etc.). I don’t want to complicate things more by explaining in this post how to go about doing this, but if you’re interested you can easily find many sources explaining it.

Remember, though, that free cash flow can also be manipulated (don’t accept cash flow from operations as always being correct). Companies will try manipulating anything and they can also manipulate cash. For instance, say a company realizes it will have a negative cash flow from operations for an upcoming quarter. To raise more cash, it can sell off its account receivables (money it would receive later on) at a discount. Although it will be able to keep a healthy cash flow for the upcoming quarter, it’s obviously hurting itself in the long run taking in less cash than the original account receivables were worth.

Hope this didn’t complicate things more for you.

[/ QUOTE ]

I disagree with most of the opinions here. The technical stuff is all right. I'm a GAAP guy in general.

Krishan

[/ QUOTE ]

Krishan. Please try explaining your opinions when you get the chance. I'm always trying to learn and it's hard to if you're just going to state that you disagree. This could turn into a useful discussion for anyone out there, as it truly is the core of financial analysis.

[spider]

[ QUOTE ]
Companies are no longer allowed to amortize goodwill. It can only be impaired.

[/ QUOTE ]

OK, I am farther behind on accounting than I realized. Thanks for the correction, although I'd also mention that a firm could take an annual impairment charge such that they are effectively amortizing. I don't know what firms have been doing in practice so I'll do some research and try to get myself up to speed on this...

Enjoying the discussion from people who know accounting. Might be even better if we didn't quote 8 paragraphs at a time... [img]/images/graemlins/grin.gif[/img]

[krishan]

[ QUOTE ]
[ QUOTE ]

I disagree with most of the opinions here. The technical stuff is all right. I'm a GAAP guy in general.

Krishan

[/ QUOTE ]

Krishan. Please try explaining your opinions when you get the chance. I'm always trying to learn and it's hard to if you're just going to state that you disagree. This could turn into a useful discussion for anyone out there, as it truly is the core of financial analysis.

[/ QUOTE ]

I just think accrual accounting makes a lot of sense. Especially as a default when looking at a company. You might get or spend cash for a number of reasons that aren't directly related to the business. I think a lot of time, working capital shifts makes companies look better than they are. Look at KSW.

http://finance.yahoo.com/q/is?s=KSW&annual

http://finance.yahoo.com/q/cf?s=KSW&annual

2006 net income of 2.7M. Cash earnings of 8.5M. But the cash earnings are all working capital shifts+deferred taxes. In fact, it's not clear from the yahoo stuff but a part of the working capital shift is in retainage which is expected to reverse. The point it more that you have to understand why cash is what it's doing, what GAAP is saying and figure out what the company is really worth on a epeatable/sustainable basis. FWIW KSW has generated 2.7M of cash on 1.5M of net income through 6 months this year. So on track for an increase in NI and dramatic decrease in FCF. I think KSW is a very clear example of a company that needs to be looked at from a GAAP perspective (maybe + stock comp).

[ QUOTE ]
Remember, though, that free cash flow can also be manipulated (don’t accept cash flow from operations as always being correct). Companies will try manipulating anything and they can also manipulate cash.

[/ QUOTE ]

Even without any overt manipulation, cash flow from operations will never be clean. That's the point of GAAP to provide a clean picture of a companies earnings excluding seasonality/changes in working capital. So you can look at GAAP and know at least in theory that is how much the company can earn. Looking at the cash flow will always take work to figure out where the extra cash is coming from. You can't just start with FCF and come to any conclusions.

Feel free to ask more questions if you have em.

Krishan