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Spend a little time reading about investing and business valuation, and you will inevitably come across the “golden rule” of business valuation: a business is worth the value of all future free cash flows, discounted to present value. . This, of course, sounds simple, but it actually involves a lot of guesswork when it comes to determining things like expected growth in cash flows, as well as how much to discount. Even something as simple as determining what Current Free cash flow can cause arguments among seasoned investors! In this article, we will look at some formulas that are used to determine current free cash flow and give an idea of ​​which one is the best. But first, let’s review why it is such an important concept.

By definition, free cash flow is the amount of cash generated by a business that is not necessary to maintain its operations. Since the purpose of any business is to generate cash for its owners (otherwise why be in business?), You can see why free cash flow is really the most important statistic in investing. Please note that we are talking about cash here, not reported Profits or net profit. The difference can be significant, as reported earnings often involve assumptions involving the value of intangible assets and certain expense items such as stock options. Cold cash, on the other hand, is as tangible as possible and cannot be manipulated by accountants. Free cash flow is the remaining amount that can be used to provide shareholder value in a number of ways: by paying a dividend, by repurchasing shares, or by reinvesting in the business to increase revenue and profits.

The traditional textbook method of calculating free cash flow is as follows:

Free Cash Flow = Net Income + Depreciation / Amortization – Capital Expenditures

This method is recommended in many old investment books. Start with net income, the approximation of the profits made in a given period. Depreciation and amortization are added again as they are not cash charges … assets that are depreciating have already been paid for as capital expenditures in a prior period. Other non-cash charges, such as write-off of goodwill or intangible assets, may also be added here. Finally, capital expenditures are subtracted, as they represent the cost of maintaining or replacing the assets that the business depends on for profit. The amount left over is the free cash flow.

As I mentioned, this is an older equation, from a time before the cash flow statement. The Federal Accounting Standards Board (FASB) only began requiring a cash flow statement for publicly traded companies in the US in 1987, and international standards followed in 1994. Before that, the state Results was the only thing available to use, and determining capital expenditures was actually filmed in the dark (requiring some serious investigation in SEC files to approximate). Now, however, we can get closer to what “true” free cash flow is, which brings us to our next equation, which uses the information from the cash flow statement:

Free Cash Flow (FCF) = Net Cash from Operations – Capital Expenditures

Now we no longer have to guess the amount of non-cash charges or capital expenditures; Companies are legally obliged to inform us of both! Net cash from operations is a real value of the amount of cash that came into the business in a period, and capital expenditures are a real value of how much was spent on property and equipment. This equation gives us a true approximate value of the amount of available cash left.

But this is not yet a really accurate picture of how much cash a business is producing. Consider the following example. A new retail concept has been successful in a limited area and management has decided to take it nationally. For many years, the company continues to open new stores, expanding into new markets and saturating those in which it was already active. After this period of growth, the concept has exhausted its potential and new store openings decline. In fact, this scenario happens all the time, and depending on the stage of business evolution, using the above equation for free cash flow presents a very misleading picture. An example is Home Depot (HD):

Home Depot 2001 FCF = 2.796 – 3.558 = -762

Home Depot Current FCF = 5.359 – 2.451 = 2,908

By 2001, Home Depot was expanding rapidly, opening 172 new stores. In 2008/09, after 2 years of weak sales and a nearly saturated market, Home Depot significantly reduced new store activity, opening just 44 stores. We can see how this new store activity drastically affects capital expenditures, as the 2001 figure is more than $ 1 billion higher than 2008/09. The resulting free cash flow number is equally skewed.

But wait a minute. Was that extra billion dollars needed to maintain operations in 2001, when Home Depot had more than 1,000 less stores to keep? Of course not! Those $ 1 billion in capital expenditures (and much of the rest) was, in fact, free cash flow that was invested to increase sales and profits, providing value to owners. So to really get a useful number for free cash flow, we need to consider just maintenance capital expenditures, not growth capital expenditures.

Unfortunately, determining what is maintenance and what growth in the capital expenditure figure is quite difficult. Some companies will separate them, but it is not required and is very rare. Fortunately, there is a line that approximates what maintenance capital expenditures amount to: depreciation and amortization. This number is the amount by which current assets are being depleted, and it is reasonable to assume that the company will need to replace them at some point in the future. By using depreciation instead of capital expenditures in the Home Depot equations above, we get a free cash flow figure that makes a lot more sense:

“Sensitive Free Cash Flow” (SFCF) = Net Cash from Operations – Depreciation / Amortization

Home Depot 2001 SFCF = 2.796 – 601 = 2,195

Current SFCF from Home Depot = 5,359 – 1,906 = 3,453

Ah, now that makes more sense. Maintenance is much lower in 2001 with a store base of just over 1,200 than it is today with a store base close to 2,300. Free cash flow now more closely approximates the amount that Home Depot management also had available to implement. Today, instead of reinvesting in new stores, management has decided to save the cash and continue to pay dividends and buy back shares.

MagicDiligence always uses the “SFCF” equation when talking about free cash flow and recommends it as the best approximation when valuing the company.

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