Part 1, Lesson 12

Overview


If you’ve read through Lessons 1-11, you should now have a basic understanding of the cash flow statement.  We discussed the three sections of the cash flow statement – 1) Cash Flow from Operating Activities, 2) Cash Flow from Investing Activities, and 3) Cash Flow from Financing Activities in Part 1, Lesson 5.

These three elements of the cash flow statement when summed together will provide a bridge from the cash balance in the starting balance sheet to the ending balance sheet.  In other words, a 2017 cash flow statement will bridge the change in the cash balance from 12/31/2016 to 12/31/2017.

But how do we use the cash flow statement when valuing a company?  We will discuss valuation methodologies in Part 2 of the investment guide, but for now, let’s focus on calculating cash flow for the company and understanding the differences in the types of cash flow metrics frequently discussed in the investment community.

 

When investors discuss “cash flow,” what exactly are they referring to?


You may have heard an analyst on CNBC discuss the “cash flow” of a company, but left wondering how exactly is that cash flow being measured.  Usually, when an individual references “cash flow,” he or she is referring to the cash flow to the equity holders of the business.  Before diving into this type of cash flow, let’s discuss below how to calculate free cash flow to equity holders.

 

Free Cash Flow to Equity


Free cash flow to equity holders is essentially what it sounds like.  It is a measure of the total amount of cash flow the business generates and is available to be distributed to the owners of the business.  For most investors, this is the single most important number in determining the value of a company.  If you invest $100,000 of equity into a business, you’d like to know exactly how much cash you’ll get back, and free cash flow to equity holders is the true measure of what you’re earning on your investment.

Free cash flow to equity is used interchangeably with a number of terms including “cash flow” or “free cash flow” or “leveraged cash flow.”  It is often abbreviated as FCF (“free cash flow”) or just simply CF (“cash flow”).

Let’s discuss below a few ways of calculating free cash flow:

1. Free Cash Flow = Operating Cash Flow + Investing Cash Flow
The “correct” way of calculating free cash flow is simply adding up the Operating Cash Flow and the Investing Cash Flow from the cash flow statement.  When we add the cash flow under these two sections, it gives us a fully-baked cash flow number that is available for distribution to equity holders.  Company management could decide to use this free cash flow to paydown debt instead of distributing cash to equity holders, but the process of paying down debt also increases the value of the equity due to the reduction in the debt liability.

Let’s calculate free cash flow for Verizon:

Adding up the Net cash provided by operating activities and investing activities, we get $5.9 billion of free cash flow for 2017, $11.8 billion of free cash flow for 2016, and $9.0 billion of free cash flow for 2015.

When we calculate free cash flow in this manner, we see some large variability in the free cash flow numbers for Verizon.  Given how steady Verizon’s business is, it seems strange for Verizon’s free cash flow to go from $11.8 billion to $5.9 billion in one year.  Glancing at the investing activities section, we notice that this section includes large cash usage for acquisitions of businesses, wireless licenses, and proceeds from sales of businesses which led to some of the variability.

With all that said, these numbers represent how much cash was ultimately left for equity holders.

2. Free Cash Flow = Operating Cash Flow – Capex
Another method for calculating free cash flow is taking the Operating Cash Flow and subtracting out just Capex.  This helps to eliminate the noise from lumpy investment activities such as the acquisition or sale of a business.  As a side note, it is important to include capital lease payments in the capex figure when calculating cash flow (refer to Part 1, Lesson 8).

Using this formula, the free cash flow for Verizon was $8.0 billion in 2017, $5.8 billion in 2016, and $21.3 billion in 2015.

As an investor, we are often most interested in the recurring cash flow for a company.  In other words, how much cash is the business generating from its steady-state operations.  Cash spent on acquiring other companies or selling other companies tend to be lumpy in nature and not necessarily reflective of a company’s steady state operations.

You will notice that the capex numbers for Verizon are steady year to year at $17 billion, which makes sense for a mature company.  Using only capex instead of the entire investing activities section helps to eliminate lumpy, one-time items that don’t properly reflect the capital investment needs of the business.

The cash flow numbers using this formula still shows some large year to year fluctuation due to operating items, such as deferred taxes.

3. Free Cash Flow = EBITDA – Cash Interest – Cash Taxes – Capex
Although this formula is an approximation of free cash flow, it is very commonly used by public market equity investors since it helps to eliminate lumpy item and drill down to the best estimate of what the steady state business looks like.

Let’s calculate free cash flow for Verizon using this method.  To calculate EBITDA, we will need to refer back to the Verizon income statement (shown below).

Below, we will use operating income (EBIT) and add back D&A to arrive at EBITDA.  From there, we will subtract out the interest expense, taxes, and capex to get to free cash flow.

Free Cash Flow 2017 2016 2015
Operating Income 27,414 27,059 33,060
Plus: Depreciation and Amortization 16,954 15,928 16,017
= EBITDA 44,368 42,987 49,077
Less: Interest (4,733) (4,376) (4,920)
Less: Taxes 9,956 (7,378) (9,865)
Less: Capex (17,247) (17,059) (17,775)
= Free Cash Flow 32,344 14,174 16,517

Using the EBITDA – Interest – Taxes – Capex formula, we arrive at $16.5 billion of cash flow for 2015, $14.2 billion of cash flow for 2016, and $32.3 billion of cash flow for 2017.

Why did cash flow jump so much in 2017?  We can see in our calculation that the 2017 tax expense is showing a positive benefit of $9.6 billion vs. 2016 which had a $7.4 billion tax expense.  The tax benefit in 2017 was due to a large tax deferral that Verizon realized in 2017.  However, as a full cash tax payer in the United States, Verizon will almost certainly pay regular cash taxes going forward.

If we were to adjust the 2017 for “normalized taxes,” how would this affect our free cash flow calculation?  First, we’d have to calculate what we believe normalized taxes would be for Verizon.  For simplicity, let’s use a 30% tax rate on pre-tax income in order to calculate normalized taxes for 2017.

Free Cash Flow 2017 2016 2015
Operating Income 27,414 27,059 33,060
Plus: Depreciation and Amortization 16,954 15,928 16,017
= EBITDA 44,368 42,987 49,077
Less: Interest (4,733) (4,376) (4,920)
Less: Taxes (2017 estimated at 30%) (6,804) (7,378) (9,865)
Less: Capex (17,247) (17,059) (17,775)
= Free Cash Flow 15,584 14,174 16,517

After adjusting the tax expense to a more “normal” figure of $6.8 billion, we now end up with an estimate of $15.6 billion of free cash flow for 2017.

Let’s now compare the three methods of calculating free cash flow as outlined above:

Free Cash Flow ($ billions) 2017 2016 2015
Operating Cash Flow – Investing Cash Flow $5.9 Bn $11.8 Bn $9.0 Bn
Cash Flow per Share (Method 1) $1.45 $2.89 $2.19
       
Operating Cash Flow – Capex $8.0 Bn $5.8 Bn $21.3 Bn
Cash Flow per Share (Method 2) $1.97 $1.41 $5.19
       
EBITDA – Interest – Taxes – Capex $15.6 Bn $14.2 Bn $16.5 Bn
Cash Flow per Share (Method 3) $3.81 $3.47 $4.04

In addition to calculating the total free cash flow (expressed as billions), we have inserted the cash flow per share based on the total share count outstanding of 4 billion shares, which can be found at the bottom of the income statement.

You’ll notice that the free cash flow per share for the first two methods results in high variability of the free cash flow per share due to previously discussed factors including deferred taxes, working capital, acquisitions, etc.  If we want to forecast future cash flow based on a historical baseline, the third method provides for a much better representation of the cash flow potential of Verizon since it is not impacted by non-recurring items or unusual timing of certain items.

As you become more familiar with calculating free cash flow, you may need to adjust the EBITDA – Interest – Taxes – Capex formula to account for the specifics of that company.  For example, if a company has capital lease payments, this should be incorporated as part of its capex.  Or if a company received dividends from an equity investment or pays distributions to a minority interest, then, these dividends or minority payments should be incorporated into the cash flow.  Or if a company has a continuous need to invest more in working capital, this may be another adjustment needed to accurately portray the free cash flow generation of a business.

 

Free Cash Flow to the Firm


Free Cash Flow to the Firm (FCFF) is different than Free Cash Flow to Equity (FCFE) because FCFF is calculated prior to deducting interest expense.  In other words, FCFF – Interest Expense = FCFE.

To calculate FCFF, we would simply add back the interest expense to the FCFE calculation or not subtract out interest expense as we are calculating FCFF.  For example:

FCFF = EBITDA – Taxes – Capex

FCFF is not a term that is commonly used by the investment community.  Instead, investors will often reference “unleveraged” cash flow when referring to cash flow before interest expense.  When used in this manner, “unleveraged” indicates that the cash flow is prior to the deduction of interest expense, and “leveraged” indicates that the cash flow is after the deduction of interest expense.

Unleveraged Cash Flow = Free Cash Flow to the Firm

Leveraged Cash Flow = Free Cash Flow to Equity

 

Free Cash Flow Yield


Free cash flow yield refers to the free cash flow of a company divided by the current market value of the equity.  For example, we previously calculated that Verizon had $3.81 of FCF / share in 2017.

To calculate the FCF yield, we would simply divide the $3.81 FCF/share by the share price of Verizon.  If we use a $49 stock price for Verizon, this implies that Verizon is trading at 7.8% FCF yield on 2017 FCF.

This tells us that at a $49 stock price, Verizon stock generates cash flow “return” equivalent to 7.8% of the amount invested.  This does not guarantee that you will earn a 7.8% return, but it is a very important valuation metric that investors use in determining how much they are willing to pay for a company’s stock.

For example, at a $100 stock price, Verizon would trade at a 3.8% FCF yield.  Would you still buy Verizon stock at a lower FCF yield?  It certainly is less interesting at a $100 stock price, unless we anticipate strong future growth in FCF.

Alternatively, if Verizon stock traded at $38, this would imply a 10% FCF yield.  If you weren’t interested in Verizon stock at $49, would you be interested in buying it at a level that gives you a 10% FCF yield?  That certainly seems a bit more compelling.

This is the process of setting a market price.  Investors make this exact decision day in and day out.  Based on company news, industry news, and economic news, the value that investors are willing to pay is continually changing, and the end result is the current market price of a company’s stock.