When the O'Jays sang For The Love of Money way back in 1974, they made a point of emphasizing they were crooning about cash money. They weren't talking about post-depreciation, after interest-deductibility, after-tax earnings. They were "talkin' bout cash money... dollar bills y'all - come on now". Now I'm not sure what kind of investors the O'Jays were, but if they had simply followed their own mantra, they might have been gosh-darned good ones. Why, you ask? Well, it's pretty simple: cash is King.
When you evaluate and value a company, you want to be able to look at the money it is actually generating. We don't want this figure to be clouded by accounting tricks, or other financial maneuvers that can skew the true picture. Basically, you want to know that you're getting what you pay for. Cash is especially important in turbulent, uncertain times such as these. Now, the true cash flow of a company, for full disclosure, can be subject to some interesting tricks, but - on the whole - it provides a much cleaner picture of the health of a company.
Having a healthy cash flow, especially in turbulent periods, can be a great thing. It can give you the flexibility to alter your dividend, or initiate a stock buyback. Moreover, when markets turn sour, it can give you a nice little cushion to maintain your capital ratios if you're a financial institution. This extra little bit of cash may even allow you to avoid having to go to the markets to raise additional capital.
So how do we find the cash flow, more specifically, the free cash flow? (Free cash flow is cash not required for operating or reinvestment deemed necessary to keep your business in the exact same condition as last year). To get it: take EBIT (a.k.a the operating earnings) and multiply by (1-Tc). This yields the after-tax earnings of the firm as if it were financed entirely by equity - the EBIAT (Earnings before Interest and After Tax). It is the flow to both equity and debt holders. Now we add back the non-cash depreciation expense, subtract the capital expenditures (CAPEX, earlier noted as the reinvested deemed necessary to keep the business the same, that is, it is the value that makes the book value at the beginning of the year the same at the end of the year after taking the depreciation of the plant, equipment etc. into account - BV1 = BV0 + CAPEX - DEP). We also subtract any investments in net working capital (NWC).
We now have Free Cash Flow. But wait, there's more! What I didn't tell you, and maybe you picked up on it, but we just calculated unlevered free cash flow. This is generally what is used, because in most cases, we'd like to disregard leverage (for the purposes of comparing two companies fairly). There is actually also levered free cash flow. This is calculated in the same way, except interest payments or debt repayments are taken into account. (So to be clear, you'd take EBIT + Interest Payments in the first step.) Unlevered FCF is usually the metric used, especially for potential buyers, who are interested in changing the capital structure (read: debt levels) of the target company. That is, the current capital structure isn't very important. Levered FCF measures the flow to just the equity holders.
Now, we have the unlevered free cash flows, what do we do with them? Well, we can do a number of things. First off, we can plug them into a little model know as the Discounted Cash Flow (DCF) Model. Now, there are a lot of things to discuss about the DCF. In fact, it can be the topic of many lectures in higher finance courses. But I'll try to give a quick run down. Basically, in order to value the company, we look at all the cash flows that it creates indefinitely into the future. We want to convert future money into today's terms. Sounds easy right? Well, it's a little more complicated than that. Money has a time-value to it. There is an opportunity cost associated with it. So, we have to discount the cash flows by a rate that is deemed to be appropriate to the providers of capital. This discount rate is known in this situation as the Weighted Average Cost of Capital (WACC). The WACC accounts for the time value of money, and the risk premium associated with the cash flows.
Now, many people you talk to within the financial industry will tell you that the DCF model is highly academic, and that it's not really used in the 'real-world'. Let's just assume for a minute that this is 100% true (which it isn't); how else can we use cash flow to get a value of the company? Well, the answer lies in multiples. For instance, the Price to Cash Flow (P/CF) metric is often used for companies where the earnings number reported isn't very valuable. For instance, consider two oil and gas companies in different jurisdictions. The different tax regimes, accounting regulations can vary differently between jurisdictions. P/CF gives you a clearer picture of the true worth of the company.
The Free Cash Flow Yield can also be a handy little tool in relative valuation. Ceteris paribus, you'd like a company with a higher free cash flow yield, as the metric is the FCF per share a company is expected to earn against its price per share. That is, investors want a higher yield because investors want to pay as little as possible for as much as possible. They want to get the best deal.
So there's a little introduction to cash flow and the DCF. There is of course a lot more to discuss. Remember though, with the downturn here or coming soon depending on to whom you listen, earnings quality will once again come to the forefront, and cash will remain king.
Saturday, May 17, 2008
Friday, May 16, 2008
News and Notes for April and May
So, first off, I'd like to apologize for the lack of activity on the blog over the last few months. As I've mentioned numerous times, all of us have been on exchange, and we're now just finishing up. (For those actually at Queen's, which I hope is most of our readers, I highly, highly recommend going on exchange - easily the best decision you can make). We were literally traveling for 1.5 months straight, so little time to sit down and update this blog. Regardless, we've all kept one eye on the markets over the last few months, and a lot of things have happened in that time.
Now, getting to the markets. Way back in March, Bear Stearns was purchased by JPM in what some describe at the watershed moment of the Credit Crisis of 2007/2008. It was the denouement of the saga that has wreaked havoc on the markets since July and August of last year. With two month's hindsight, it appears to have been the bottom of the market. The Fed acted pretty quickly and swiftly, and really calmed both retail and institutional investors. Moreover, the economic stimulus package that was authorized by President Bush and Congress has just begun to kick in. This package is intended to kickstart the U.S. consumer, which makes up about 70% of the U.S. economy. This is all done in order to avoid or mitigate the consequences of the first-consumer led recession since 1991.
Many economists and analysts believe that we are already in a recession. Others believe that we will narrowly avoid one. Whichever view is correct, it's pretty clear that the road ahead is anything but smooth. Over the last two months, we've seen: more writedowns from banks, a decrease in consumer confidence (a 28-year low), a huge spike in oil prices, the fall in the U.S. dollar, rumours of ratings downgrades at major insurers, layoffs and weak job growth, a continuing slump in the U.S. housing market, and rising commodity prices and food shortages around the world. However, in the most recent earnings season, we've also seen some companies at the very least meet and, in a handful of cases, exceed analyst's expectations.
We've also seen some investors jump into the market in a big way in order to take advantage of low valuations. For instance, Warren Buffet bought a giant heap of candy, Nelson Peltz bought some burgers, Steve Ballmer and Carl Icahn have each made runs at Yahoo, and HP purchased EDS for $13 billion. Moreover, in another sign of increasing investor confidence, equity markets have rallied since Bear was bailed out in March. Turning to the credit markets, in another positive sign, yields on junk bonds have rallied since March. The Merrill Lynch Junk Bond Index now yields about 7 points more than low-risk treasuries, which is better than the 8.6% high the day after Bear collapsed. (As investors become less risk-averse, yields on junk bonds falls). Although it must be pointed out the spread was around 2% before stuff hit the fan in July '07. So, there is good and bad in the market. Have we rebounded from the lowest of the lows? Most likely. Are we out of the woods? Most definitely not. In the interim, the market will continue to digest data on a piecemeal basis.
Just getting back to the Competition for a second. We are currently working on determining an outright and risk-adjusted winner. You will get an e-mail as soon as we have the final results. The winners can claim their prize at our first meeting for the next school year in September.
Now, getting to the markets. Way back in March, Bear Stearns was purchased by JPM in what some describe at the watershed moment of the Credit Crisis of 2007/2008. It was the denouement of the saga that has wreaked havoc on the markets since July and August of last year. With two month's hindsight, it appears to have been the bottom of the market. The Fed acted pretty quickly and swiftly, and really calmed both retail and institutional investors. Moreover, the economic stimulus package that was authorized by President Bush and Congress has just begun to kick in. This package is intended to kickstart the U.S. consumer, which makes up about 70% of the U.S. economy. This is all done in order to avoid or mitigate the consequences of the first-consumer led recession since 1991.
Many economists and analysts believe that we are already in a recession. Others believe that we will narrowly avoid one. Whichever view is correct, it's pretty clear that the road ahead is anything but smooth. Over the last two months, we've seen: more writedowns from banks, a decrease in consumer confidence (a 28-year low), a huge spike in oil prices, the fall in the U.S. dollar, rumours of ratings downgrades at major insurers, layoffs and weak job growth, a continuing slump in the U.S. housing market, and rising commodity prices and food shortages around the world. However, in the most recent earnings season, we've also seen some companies at the very least meet and, in a handful of cases, exceed analyst's expectations.
We've also seen some investors jump into the market in a big way in order to take advantage of low valuations. For instance, Warren Buffet bought a giant heap of candy, Nelson Peltz bought some burgers, Steve Ballmer and Carl Icahn have each made runs at Yahoo, and HP purchased EDS for $13 billion. Moreover, in another sign of increasing investor confidence, equity markets have rallied since Bear was bailed out in March. Turning to the credit markets, in another positive sign, yields on junk bonds have rallied since March. The Merrill Lynch Junk Bond Index now yields about 7 points more than low-risk treasuries, which is better than the 8.6% high the day after Bear collapsed. (As investors become less risk-averse, yields on junk bonds falls). Although it must be pointed out the spread was around 2% before stuff hit the fan in July '07. So, there is good and bad in the market. Have we rebounded from the lowest of the lows? Most likely. Are we out of the woods? Most definitely not. In the interim, the market will continue to digest data on a piecemeal basis.
Just getting back to the Competition for a second. We are currently working on determining an outright and risk-adjusted winner. You will get an e-mail as soon as we have the final results. The winners can claim their prize at our first meeting for the next school year in September.
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