Tuesday, August 21, 2012

Investing Tutorial - Part 4 (Stock Valuation)

Last post, we were still talking about valuation metrics. We stopped on the metric of price to book value and today, we will discuss what I believe to be the most useful valuation metric of all when valuing a stock - price to free cash flow (FCF).

I will be explicit about the definition of free cash flow, but let me first explain why I think the other metrics are inferior to it. The reason that I believe price to free cash flow is the most useful metric of margin of safety, or how expensive a stock is, is because there are a whole lot of really intelligent and clever accountants who work in the corporate finance departments of major companies. These very intelligent accountants also have a mandate from corporate management to make earnings numbers look as good as they are allowed to, within the legal boundaries of "GAAP"  (Generally Accepted Accounting Principles). When accountants "massage" earnings numbers or engage in other financial sleight of hand, it's hard to get a true grasp on the "E" in the P/E ratio. Similarly, these same accountants can manipulate the value of assets and liabilities on a corporate balance sheet (at least temporarily), and this means it's hard to trust the price to book value ratio. Recall that in our last post, we defined book value as total assets minus total liabilities. Free cash flow on the other hand - well, it's hard to fake that. To paraphrase the saying, free cash flow is king!

So, what exactly is free cash flow? Well, there's a complex formula that's used to calculate it and if you're a stickler for details, you can find it here. But in layman's terms, it is the money that is left over to pay shareholders dividends after the company has used the money necessary to continue day to day operations. Here's an example. Let's say you own a small trucking company with a fleet of five trucks, all of which you use on a daily basis. Let's also assume that 3 of the 5 trucks break down. If you absolutely must have all 5 trucks in order to conduct business, then you have to either fix the 3 trucks that are not working or buy 3 new trucks. The money that is left over at the end of the year after making the necessary repairs/new purchases is free cash flow. 

Some investing experts suggest that a thumbnail method of calculating free cash flow is by subtracting "capex" or capital expenditures from operating cash flow. (It should be noted that capex can be found in the investing section of a company's statement of cash flows. Operating cash flow can be found at the bottom of the "Operating Activities" of a company's statement of cash flows. And all of a company's financial statements can be found in its quarterly and annual filings at the Securities and Exchange Commission's website.

To bring it all together, when you use the price to free cash flow metric, you are essentially figuring out how much a company is charging you for it to make money for you. It's kinda like a recent college graduate asking you how many times his yearly salary of $40,000 are you willing to pay for him to fork over his entire lifetime earnings. I believe that most people would say that paying $160,000 (4x his current salary) for his life time earnings would be a steal. Even $200,000 or $240,000 still seems like a steal. But the higher the multiple of his current salary gets, the harder it is to justify paying for that stream of income. The same goes for stocks as their multiples of price to free cash flow goes higher and higher.

Remember, with the price to free cash flow ratio, you are paying a certain factor of a company's earnings stream. When you are getting a large earnings stream for really cheap or a reasonable price, you do not have to worry as much about your growth projections being wrong - so long as the company has a history of steady production of a certain amount of cash flow.

In our next post, we will talk about some common personal finance wisdom that you can go against because doing so actually empowers you. Until next time...

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