PDF Version: P123 Strategy Design Topic 3C – Valuation Based on Cash Flow
The rationale for use of cash flow as part of valuation is exactly the same as with earnings. It’s the pool of money from which dividends are, will, or can be paid. Hence cash flow enjoys the same logical connection to DDM as does earnings-based valuation.
Let’s review our logic.
DDM:
- P = D / (k-g)
- Substituting E for D (see Topic 3A)
- P = E / (k-g)
- With some algebraic reshuffling:
- P/E = 1 / (k-g)
Moving on:
- P = D / (k-g)
- Now, we substitute CF (cash flow) for D (analogous to use of E)
- P = CF / (k-g)
- With some algebraic reshuffling:
- P/CF = 1 / (k-g)
Therefore, as with P/E, we understand that:
- Higher interest rates (included in k) make for lower P/CF ratios
- Higher growth rates (g) make for higher P/CF ratios
- Higher risk (included in k) makers for lower P/CF ratios
An Oddity?
Is it possible that the exact same items in the exact same formula can produce an ideal PE and an ideal P/CF? Does that mean these two ratios must be the same?
In a very strict sense, if mathematical precision is absolutely needed, then we would say that the “g” items changes. In DDM, it refers to expected growth in dividends. With PE, it refers to expected growth in earnings. In a similar formula relating to PS or EV2S, “g” means expected growth in sales. It would, therefore, follow that here, “g” refers to expected growth in cash flows. So the math is effectively covered.
That said, mathematical precision is not our goal. We live by the adage that its better to be vaguely right than precisely wrong and eagerly embrace approximation. Remember why we’re working with these price-based ratios in the first place. We use them as a tool to help point us toward stocks more likely than not to be aligned with the ideal but incalculable DDM valuation. To do our jobs, to identify promising investment opportunities in the unknowable future, we need not obsess over the details of a growth projection. All we need do is recognize (and address in our models) that all else being equal, higher growth expectations impact (in an upward direction) the reasonableness of a price-based ratio. This sort of approximation does not amount to shirking in any way. Actually, modeling for it is the most challenging task we face and inadequacy in this area is a major reason why a value strategy that performs well in tests can still fail when applied in the future, with real money.
So let’s move on to the truly big question for today:
Cash Flow Versus (?) Earnings
Having already worked with PE, we know exactly how to strategize with P/CF. The issue to consider, here, is whether we shouldstrategize with CF. Or should we stick with E. Or should we use multiple factors. (As you already know, I am favorably inclined toward multiple factors.)
Cash flow is much revered in this generation as a tool for value. Many have heard the expression “Cash is king.” Generally, that refers to cash accumulated on the balance sheet. But absent big unpredictable one-off gains, it’s not as if you can build balance-sheet cash without some healthy periodic operating cash flows. In terms of cash flow itself, you may have heard it suggested that this is more important than earnings because it’s real (as opposed to a concoction that is the end results of a lot of accounting voodoo). And in a more perplexing vein, you may have seen cash-flow-based valuation exalted in certain industries (i.e. media, real estate) where earnings are non-existent or written with red ink.
Try to banish all such sayings from your minds. Cash flow is, essentially, earnings. It’s just calculated in a different way from what is used to derive net income and it provides a different perspective on the same question.
Which is better, net income or cash flow? Answer: Both of the above. Neither is better or worse than the other. Both perspectives are very much worth knowing.
To truly understand cash flow, we’ll have to go back to Earnings and the Income Statement, and understand why it is the way it is. Is it because accountants and CFOs like gobbledygook? Or is there something going on that the cash-flow police are missing? (Answer: It’s the latter.)
Another Oddity
Although this Topic is about cash flow, I’m actually going to talk a lot more about earnings. That’s because if an investor messes up by using cash flow, the mistake will come because he or she overestimated its importance. The investor thought cash flow was providing the sort of analytically critical information that is, in fact, provided by earnings.
This is not to say cash flow should not be used. I use it regularly. The easy part is plugging it into models (as I said, substitute CF for E in your rules or factors and you’ve nailed it). The hard part is recognizing when and why you might choose to use it. And to do that, we need to really understand what the income statement (the thing so many cash-flow devotees scorn at) actually does. If you get that, the rest (cash in minus cash out) will easily fall into place.
The Rationale For Earnings
The goal of the Income Statement is paint an economic portrait of the company by matching revenues with the associated expenses.
This sounds obvious and simplistic. Of course we need to match revenues and expenses! But in real life, it can be very difficult to do that. Consider this example:
I want to make and sell hammers. And since I’m a good citizen and want to create jobs, I’m not going to outsource production. I’m going to build a factory in the good old U.S. of A. I raise $100 million to do that and spend a year on construction. Finally, right after New Year, it’s ready to enter production.
During the first year of actual operation (year two of my company’s existence), I sell $8 million worth of hammers. Marketing expenses, raw materials, and overhead amount to $6 million. That means pretax profit is $2 million. After paying 35% of that for taxes, my net income (E) is $1.3 million.
Nice! Good profit. I’m off to a great start.
Or not.
Did I really earn $1.3 million? I got $8 million in revenue. I know (because I’ve got a great and meticulously accurate CFO) that my expenditures (including taxes) were $6.7 million. So there!
No. What about the $100 million factory I built in Year One? I used that to produce the hammers. Do I just acknowledge that the first year was a disaster, zero revenues and expenses of $100 million for a $100 million net loss? Wow, that means I grow from minus $100 million to plus $1.3 million. Portfolio123’s Sales%ChgA will show a 101.3% growth rate, based on (+1.3 – -100)/abs(-100). Chances are my company will be ranked well above 90 in ranking systems that prominently feature Sales%ChgA.
Does that sound reasonable? Does that really help investors? Or can the accountants trot out some magic that helps us reach an economically sensible investable conclusion?
Let’s try this. We’ll close our eye completely to Year One as a formative year that is not at all reflective of underlying fundamental prowess. We read on the somewhere on internet about accounting deferrals. So we’ll eagerly order our CFO to defer the $100 million factory cost into Year Two, when we became operational. Investors won’t mind. They know you make to spend money to make money so they’ll respect our non-operational formative year.
And they know there will be growing pains. So they’ll accept a Year-Two loss of
$98.7 million; $8 million in revenue minus $6 million in general operating costs minus $0.7 million in taxers minus $100 million for the factory. Is that right? Did I readjust taxes properly? Aw heck. That’s a little detail. My accountant will fix it. The final number may not be exactly minus $98.7 million. But it will be in that vicinity. More importantly, my Investor Relations VP will coach analysts to value the stocks based on PS and/or EV2S. That’ll hold the fort until year 3, when I’ll sell another $8 million in hammers, have another $6.7 million in costs and, since there is no more factory building, generate a genuine $1.3 million in profit. My expectation is for the same year after year.
Again, no! The factory is going to produce a lot of hammers for a long time. It makes no sense to allocate the entire $100 million only to the hammers produced in any single year.
After my accountant finishes laughing at my idiotic excuse for a set of financial projections, he’ll educate me on how it’s going to really be done.
Year one is an oddball year, no doubt about that. But again, it’s not indicative of the future. So I really don’t understand or care about what he does for that year’s income statement. But for the real statements . . .
I need to estimate the “useful life” of the factory (how long it will be able to keep producing hammers) and allocate to each year a proportionate part of the $100 million. I estimate the factory will be good for 50 years, after which time it will be worthless (zero value). So I “depreciate” the factory by charging 1/50thof its cost ($2 million) in each year.
Oh. Damn. Before, when my CFO cowardly allowed me to avoid depreciation (this is why investors should appreciate independent auditors), I had assumed $2 million of pretax profit. Now, I have to subtract another $2 million. That leaves me with . . . aw hell, nothing, zero, nada. L
So what was all that internet chatter about how accounting voodoo misleads investors who rely on the Income Statement? Actually, it was my accountant who told the truth. The business that I thought was great $1.3 million in annual profit is actually a flat-out piece of crap.
Not so fast. I just saw on CNBC where some hotshot was mouthing off about how earnings really are BS. He reminds us of the DDM, and how its dividends we care about. That’s big. Depreciation is a non-cash charge. When it comes to funding dividends, I’m still looking at $1.3 million per year. Phew. Stupid accountants . . . $*&@ them.
No.
What happens if you don’t eat? You starve and die. What happens to an old-time farmer if he doesn’t feed his oxen? They starve and die and he can no longer plow his fields. What happens to a trucking company that doesn’t do maintenance on its trucks? They break down and revenue goes to zero. And . . . what happens to me if I starve my factory, if I don’t continue to spend to keep it functioning properly? It will mess up and eventually be idled.
Some of that ongoing factory spending is ordinary day-to-day stuff like paying the electric bills, tightening some bolts every now and then, etc. That part of the ordinary expenses I accounted for. But just as with cars, there are small day-to-day things (air in the tires, fuel in the tank, oil change) and big things (replacing a transmission). Ditto factories. The big things come under the heading Capital Spending. That’s money that must be spent. But it’s not counted on the income statement, which only addresses the ordinary day-to-day things. As a practical matter, real-world CFOs tell analysts that depreciation is a pretty decent proxy for the capital spending that doesn’t get directly logged into the income statement. So in an economic sense, depreciation usually counts – big time. Put another way, if I’m dumb enough to use my annual $1.3 million to fund the dividend, I’m going to find myself prematurely out of business when the factory breaks down. And that’s why PayRatio the percent of earnings paid out as dividend, is computed based on net income as opposed to cash flow!
Matching revenues and expenses didn’t come easily. It often doesn’t. This is one example of many in which expenses incurred in a single period have to be matched with revenues over many periods. And it gets more complicated if the factory goes obsolete earlier than expected, in which case we have to “write off” the un-depreciated value, or if it’s enhanced by new equipment (add that to the $100 million base and add another layer of depreciation tracking. And there are more variations where that came form. (That’s one reason why CPAs earn their money.) But however hard it can be to match revenues and expenses, it’s often valuable to do so. Not having done that on our first go round caused us to be misled into believing we had a profitable business when in fact, we were just breaking even.
The bottom line: Earnings are important. Depreciation and many other accounting adjustments like it are necessary to give us an economically valid picture of how a business is performing. So do not ever use cash flow based valuation simply because you buy into nonsense to the effect that earnings are BS and that only cash flow matters. The only valid reason to use cash flow in the course of valuation is because you knowingly choose this as one of two equally reasonable measures of performance. And that leads us to a discussion of what cash flow is and what it tells us.
The Rationale for Cash Flow
We need not be intimidated by the importance of earnings. Cash flow is trivial. It, too, is valuable, bit in a different way (not better, not worse, just different). Cash flow defines profits exactly as one who has not studied accounting might expect; the amount of cash taken in by a business less the amount spent. To systematize this, the Statement of Cash Flows is organized on the basis of three sections that correspond to the three ways companies collect and disburse cash:
- Operations:
This refers to the regular conduct of business activities. Essentially, the bottom line for this section of the statement is Net Cash Provided/Used by Operations and is similar to net profit, revenues minus expenses. The difference here is that we are not interested in painting the sort of economic portrait we get when we match revenues and expenses. We just care about cash in minus cash out – in minus out not in total but as it pertains to regular business activities. The differences between this and the earnings (net income) we see on the income statement are known as “accruals.” Depreciation is an accrual, perhaps the largest and best-known accrual. There are others. And as we saw in the last section, accruals can be essential to our understanding of company fundamental prowess. And as we’ll see in a later topic (earnings quality), they can also serve to obfuscate.
- Investing:
This refers to business activities outside the normal course of the company routine. The most noteworthy examples of Investing-oriented expenditures are capital spending, acquisitions, and long-term investments (i.e. Company A purchases an equity stake in Company B). The most noteworthy examples of Investing-oriented inflows are proceeds from divestitures of assets. (The Incomes Statement is concerned with the profit or loss on such divestitures. The Statement of Cash Flows is only concerned with the amount of cash that comes in. “Double-entry” accounting reconciles the three financial statements, Income Statement, Statement of Cash Flows and Balance Sheet to make sure everything evens out in the end.) The bottom line for this section of the statement is Net Cash Provided/Used by Investing.
- Financing:
This tracks how companies get and disburse capital. When a company gets an infusion of equity (a new company conducting an I.P.O., a private-company founder initially funding the company bank account, new equity sold in the secondary market, new equity sold to a private investor, cash received by employees exercising stock options, etc.), it gets logged here. Ditto proceeds received from the issuance of debt. Outflows of capital are also tracked, the most noteworthy one being payment of dividends to shareholders. Other Financing disbursements include funds used to repurchase shares and the paying down of debt. (With respect to debt, interest is not recorded here; that’s an operating expense. In this area, we’re only concerned with expenditures that reduce the amount of outstanding debt capital.) The bottom line for this section of the statement is Net Cash Provided/Used by Financing.
The overall bottom line for this statement is the net change in cash.
The information here is of obvious importance to management, the folks who are responsible for making sure the bills get paid.
For investors, this information is not the end-all and be-all of fundamental prowess. In fact, it is arguably not even primary. We saw above, with the example of the hammer factory, how important accruals can be in depicting the economic condition of a business. Investors who are interested in the future (i.e. DDM-based valuation and real-world metrics that can point us in that direction) need that perspective.
Cash flow information interests investors in a more immediate sense. It gives us a direct here-and-now window into the ability of the company to disburse cash in ways that are important to us, namely regular dividends, special dividends, share buybacks, etc. It depicts the capacity of companies to do special nice things for shareholders sooner rather than later.
And for struggling companies, it helps us gauge survivability. Back in the late 1990s and early 2000s, one truly big mistake investors made was not paying close enough attention to the Statement of Cash Flows, particularly the negative bottom lines, or the “cash burn” or “burn rate.” Yes, the sales-based stock valuations were sky high. But as we saw in Topic 3B, that’s fine if justified by “g,” i.e. if the company can execute its visions and achieve sales that grows into and hopefully beyond investor expectations. The real killer was cash burn. Those who studied this saw that many companies would not be able to survive long enough to execute their visions. And to refresh memories, the early 2000s Jack Willoughby Barron’s article that sent internet stocks into their first notable tailspin was focused entirely on cash burn. The CLECs (if you don’t know or remember what that means, don’t ask, it was ugly) vaporized for the same reason.
Defining Cash Flow for Modeling Purposes
Traditionally, the definition of cash flow was simple. It was Net Income plus Depreciation, the premier non-cash accrual that impacts the income statement. This classic metric is included among pre-set Portfolio123 items, at least on a per-share basis; CashFlPS (specifically, it’s Income After Taxes minus Preferred Dividends plus Depreciation and Amortization).
That definition, while correct in a traditional sense, may not fit best with what contemporary investors are seeing to accomplish when they value stocks on the basis of cash flows. Typically, they go one of two ways both of which are reflected in Portfolio123 factors that reject the potential oversimplification inherent in the classic definition:
- One approach is to simply use Cash From Operations, the bottom line figure from the uppermost portion of the Statement of Cash Flows: OperCashFl. This embraces traditional cash flow (i.e. it includes net income plus depreciation and amortization) but goes further and adjusts net income for the impact of all other accruals.
- The other measures the portion of OperCashFl that is not already spoken for by decisions the company has already made and wants to continue to honor so long as it is not precluded from doing so by specific reasons. These spoken-for subtractions are dividends and capital spending. The Portfolio123 factor at which we are aiming is Free Cash Flow, or FCF. It is OperCashFl minus dividends (DivPaid) and minus Capital Spending (CapEx).
Therefore, when we work with FCF, we’re not working with the cash flow the company technically can use to benefit shareholders (that would be OperCashFl). We’re instead, looking at the cash flow the company could, as a practical matter, use to benefit shareholders after having taken into account pre-existing decisions regarding capital spending and dividends.
The case for accepting these adjustments and choosing FCF lies in its market orientation. The market knows what the company is about now; that’s already (presumably) reflected in the stock price. FCF focuses on the potential for incremental enhancements to shareholder wealth, things the company could do above and beyond what it has already committed itself (by preference and custom if not law) to do, things that may not be factored into the current stock price. The case against FCF lies in its potential for volatility. Capital spending often does not follow a smooth trend. It can ebb and flow, sometimes sharply, as major capital projects ramp up or wind down.
You can also get creative and come up with your own definitions of cash flow. For example, I spoke of capital spending as if it were a single idea. In truth, it’s not; we just treat it that way because that’s what the financial statements and the databases do. In truth, though, there’s “maintenance capital spending” (the type discussed in the above example of the hemmer factory) and “growth capital spending” (i.e. where the hammer-producing company spends discretionary funds on growth ventures, such as the building of a factory to support its planned entry into the screwdriver business). When Warren Buffet evaluates companies under what he calls “owner earnings” (his own version of cash flow), he adds back depreciation and instead of adds subtracts his expectations of maintenance capital spending. He knows that as well-planned as a capital program may be, if he acquires the company, he can cancel growth capital spending and use the money for other purposes.
So how can you define growth and maintenance capital spending? That depends on you and your imagination. There is no objective answer.
Consider, too research and development. That’s treated by accounting rules as an operating expense and is deducted in full each year as part of the computation of earnings. R&D-heavy tech companies hate this; they maintain that for them, this is the functional equivalent of capital spending (some maintenance, some growth) and should be treated as such. You can experiment by assuming all or most of it is analogous to growth capital spending and design some rations that compare price with your customized version of cash flow in which R&D is reassigned by you in whole or in part to the cash flow statement. (Now, are you starting to see why, early on, I made a big deal out of demonstrating use of the ShowVar function?)
How Should Cash Flow Valuation Figure Into Strategies
As noted at the outset, the kinds of factors/rules and supporting factors/rules used in earnings-based valuation can be used here. There is no hard and rule for saying whether earnings or cash flow are better. As long as one understands what each tells us, either or both can be used.
In fact, because both have their merits, this is an instance where it would be reasonable to make a choice based on which backtests better – again subject to the proviso that one understands the nature of the message having been thusly delivered by the market and have reason to assume the market won’t significantly alter its views going forward. For example, share buybacks have been much desired by investors lately. That trend has persisted for a while and has a lot to do with why FCF valuation has been productive. If however, one believes that circumstances are likely to cause the investment community to rethink its advocacy for this sort of thing may lose some luster.
Additionally, the relative merits of earnings- sales- and cash flow-based valuation are such that multi-factor (“all of the above”) models can often be successful – so long as we remember to incorporate growth risk and margin into our models.
Next Up – A Change of Pace
So far, it’s been easy to recognize the logical connections between valuation metrics and DDM. Sales, earnings and cash flows all one way or another measure ongoing corporate wealth creation thus running along the same path as the Dividend Discount Model.
Our next topic, Price/Book Value will represent a change of direction in that we’ll bring the balance sheet into the picture. We’ll retain the link to DDM, as we always must. This time, however, we’ll have to work a bit harder to see it.
Acti-quant 