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By Whitney Tilson December 12, 2000 Revenues to some extent and net income to an increasingly large extent in this market are opinions, but cash is a fact. Thats why I spend so much time focusing on companies cash flow statements. The key number I look for is free cash flow, which is the excess cash the company is generating from its operations that can be taken out of the business for the benefit of shareholders via dividends, share repurchases, new investments, acquisitions, and the like. To calculate this figure, a few adjustments must be made to the cash flow from operating activities shown on the cash flow statement. In my column two weeks ago, I showed how to calculate Lucents NYSE: LU cash flow from operating activities for each of the first two quarters of FY 00. Now lets make the necessary adjustments to arrive at free cash flow. Note that if you put 10 analysts in a room, gave them identical financial statements, and told them to calculate free cash flow, you might get 10 different answers. Theres a lot of judgment involved, so you shouldnt necessarily take my approach as gospel. Adjusting for taxes There are often items in the cash flow statement under operating activities that have nothing to do with a companys actual operations. Do you think the tax deduction a company gets when its employees exercise stock options should be counted as cash from operating activities? I dont, so while new SEC regulations require companies to report this under Operating Activities, I always move Tax benefits from stock options to Financing Activities whenever I see it under Operating Activities. Unfortunately, many companies do not break out this line item separately, so you cant make the adjustment. In addition, some companies continue to report this figure under Financing Activities. Similarly, I dont believe that changes in Deferred income taxes have anything to do with operations either, so I move this line item as well. Adjusting for cap ex The most difficult adjustment is for capital expenditures, which reflect spending to maintain and build property, plant and equipment. For some companies, other items such as Software development costs or Purchase of software licenses would also be included in cap ex. These expenses are depreciated over many years, but since depreciation reflects cap ex in the past, its not a cash cost today. Thus, it is added back on the cash flow statement under Depreciation and amortization.
But to balance adding back the non-cash cost of depreciation, you must subtract the real cash cost of cap ex, which appears under Investing Activities in the cash flow statement. The goal is to subtract what a company must spend to maintain its existing operations and market position. But what if a company decides to invest in a new line of business and makes big capital expenditures - funded from its free cash flow - to do so? This growth cap ex is not a requirement of the business, as the cash could have been returned to shareholders, but management determines that it can generate a high rate of return from this additional cap ex. In this case, one must estimate how much of a companys cap ex is for maintenance - and subtract this amount to arrive at free cash flow - and how much is for growth, which should not be subtracted when calculating free cash flow. I dont have the space in this column to give this subject the treatment it deserves, so I have posted further thoughts on the Fool on the Hill discussion board. For simplicitys sake - and to be conservative - I generally deduct all cap ex to arrive at free cash flow unless I have a concrete reason to do otherwise. Other thoughts on cash flow Depending on the company, other adjustments to free cash flow may be warranted. For example, there may be line items beyond those Ive mentioned that appear under Operating Activities in some companies cash flow statements that you feel dont truly relate to operations. You may also want to adjust for unusual or one-time gains or charges. For example, American Power Conversion Nasdaq: APCC in Q2 00 had a one-time litigation payment of $472 million, which I excluded from my calculations of operating cash flow. Im afraid there are few hard rules - you just have to use your judgment.
Incidentally, I always worry when I see a big jump in this number, as it can - though it doesnt always - mean employees see storm clouds on the horizon or simply believe the stock is overvalued and are consequently exercising their stock options and selling. I have posted further thoughts on this topic and how it relates to Lucent on the Fool on the Hill discussion board. I did not include a column for Q3, however, because of Lucents financial restatements due to its spin off of Avaya. In next weeks column, Ill share some data on what happened to Lucents cash flow in Q3 and how to handle not-uncommon situations in which there is imperfect data. Lucent provides an excellent case study of how important it is to adjust operating cash flow to determine free cash flow.
Now that we have the numbers we need to begin our analysis of Lucents cash flows - I havent done any analyses yet - Ill stop and let you think about what these numbers mean. See my column two weeks ago for a detailed look at Lucents entire cash flow statement. At what point might analysts and investors have realized that something was seriously amiss? Ill share some of my thoughts regarding these questions next week. Conclusion Keep in mind that free cash flow is not the only way - and often not even the best way - to evaluate and value a business. A company might choose a strategy that results in declining or negative cash flows in the short run, but creates immense shareholder value in the long run. However, understanding and being able to calculate free cash flow is a critical tool that every investor should possess. This isnt calculus - its copying data and then doing some basic addition and subtraction, nothing more.
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