How to value a company – cash flow statement

Foreword

This post discusses some common techniques on evaluating the fundamental value of a company by looking at its cash flow statement, for those who are investing, as defined in Investing vs Speculating.

There are, of course, other ways of evaluating the value of a company, which we will cover in other posts. Other posts in this series:

• How to value a company – income statement
• How to value a company – balance sheet

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Show me the money

If, after reading How to value a company – income statement, you come away thinking there’s way too many finance gobbledygook in there about stuff that aren’t really about cold hard cash, like depreciation, accounts payable, etc., and you’d really just want to figure out whether cash is coming in or leaving the registers. Then you may be tempted to just throw away the income statement and just scream, “Show me the money!”

And you wouldn’t be alone.

This is where the cash flow statement comes in. As the name implies, it is, literally, a statement of the cash flowing into and out of the company. Gone are the hand-wavy “assets” and “costs” like accounts receivable and depreciation. Gone are the confusing terms like “operating costs”, which for some reason, don’t include the costs of actually producing the products (what’s up with that?). Everything is broken down into 5 very simple lines, which tell you exactly how much cash is coming into (or leaving!) the company’s coffers and where they are from (or are going).

Common accounting terms

There’s really only 5 lines on the cash flow statements that are important. Yes, there are probably like 30 lines on an actual cash flow statement (we’ll get to them later), but the 5 important lines are:

Net income	This is always the first line in the cash flow statement, but always the last line in the income statement. In both cases, this is the same number, and mean the same thing. Net income, defined in the earlier post, is the glue that joins a company’s income statement to the cash flow statement.
Total cash from operations	This is the actual amount of cash, moving into, or out of, the company, due solely to its operations. Usually, this value is derived backwards from net income by adding back (or taking out) all those line items that aren’t strictly about cash flows due to operations. For example, Depreciation is added back in, because it’s not an actual cash expense. Accounts payable are added back in, because we haven’t paid our suppliers yet, and the cash is still sitting on our balance! Similarly, accounts receivable is taken out, because we haven’t been paid yet.
Total cash from investing	This is the actual amount of cash, moving into, or out of, the company, due solely to investing activities. This includes things like buying new factories, new equipment, buying another company, etc. For example, If our company buys a new factory for $100,000, then this value is reduced by $100,000. If our company sold a previously bought factory for $120,000, then that is reflected as an increase of $120,000 in this value. If our company did both, and had no other investing activities, then the total cash from investing = -$100,000 + $120,000 = $20,000.
Total cash from financing	This is the actual amount of cash, moving into, or out of, the company, due solely to financing activities. This includes things like taking out a new loan from a bank, paying off an old loan, paying a dividend to shareholders, etc. For example, If our company took out a new loan of $10,000, and paid off an old loan of $9,000, then the total cash from financing = $10,000 – $9,000 = $1,000.
Net change in cash	This is the actual change in the cash balance of the company. This is simply “cash balance before this period” + “total cash from operations” + “total cash from investing” + “total cash from financing”. Sometimes, there’s a little line entry that adds or removes a little bit additional due to things like foreign exchange fluctuations. Just to spice things up a little bit.

Showing your work

Yes, there’s really only 5 lines that matter. But you know how things are. We can’t make life too simple — where’s the fun in that? In general, a cash flow statement will contain, oh, about 30-50 lines. The lines other than the 5 lines mentioned above, are basically just the accountants showing their work.

Like in elementary school math, where you can’t just write “5”, or even “The answer is 5”. No, you have to write:
Sally has 2 marbles. Peter has 3 marbles. Total marbles = 2 + 3 = 5.

The result is the same. But the teachers prefer the latter. It makes them feel happier. Or something.

This is good for us! Sometimes the accountants (or the company itself) get things wrong. So they show their work on the cash flow statement. And we get to decide if they know how to do basic arithmetic. (1)

One thing to note: numbers in parentheses are negative numbers — cash flowing out of our company. For example, in the “cash from financing activities” section, “(5,000)” generally means we paid off $5,000 in debt. The parentheses means cash flowing out, and numbers without parentheses mean cash coming in.

And now what?

From the cash flow statement, we can discern a few very important tidbits:
Is most of the cash coming into the company via actual operations?
Or is the company being propped up by more and increasing debt?
Or by selling off assets?

Ideally, we want “total cash from operations” to be a positive number, and much larger than “total cash from investing” and “total cash from financing”.

Even better if “total cash from financing” is a negative number (we are doing so well, we can pay down debt!). Note that a positive “total cash from financing” number isn’t necessarily a bad thing. Maybe the company is raising debt to buy out a competitor and thus expanding its businesses. Or maybe the company is developing a new product line, etc. One off debt issuance to invest into the business is usually a good thing! The red flag is when “total cash from financing” is always positive (i.e: the company is always issuing debt), and always a substantial amount compared to “total cash from operations”.

“Total cash from investing” should hopefully also be a negative number, indicating the business is likely profitable and the company is investing more money into it. However, this is more nuanced.

If “total cash from investing” is always negative, and always a large absolute number, that may indicate a business that is heavily dependent on new injections of capital. For example, if a company has $1,000,000 of “total cash from operations” every quarter, but also $(900,000) of “total cash from investing” every quarter, that suggests that perhaps the company is heavily dependent on rolling over its investments every period to generate the profits for the next period.

Companies like this are sometimes at the mercy of their customers — if they also have a large accounts receivable, if their customers fail to pay up on time, these companies may get into temporary liquidity distress.

Even without being at the mercy of their customers, these companies generally don’t tend to perform as well — the need for heavy capital reinvestment makes it hard to scale the business, because it is not always possible to find enough capital to deploy; At the same time, the need for heavy capital investment (as a ratio of operating profits) suggests lower profitability, which deters investors.

Free cash flow

Free cash flow tells us the core efficiency of a company’s businesses — It is simply the cash the operations of a company generate, without consideration for reinvestments (i.e.: capital expenditure).

Recall that “total cash from operations” is the cash a company generates ignoring depreciation and amortization (amongst other things). So, by starting with “total cash from operations”, we just need to take out “capital expenditure” to get free cash flow:

“Capital expenditure” is the amount of cash a company reinvests in its businesses. For example, to replace capital assets that were consumed as part of operations, or to scale the business. This is sometimes called out in the cash flow statement or income statement, but usually needs to be estimated or calculated — by looking at the income statement and deducing which line items are related to capital expenditure.

Free cash flow = total cash from operations - capital expenditure

Another form of free cash flow, unlevered free cash flow, is simply free cash flow assuming the company has no debt. In this case, interest expenses are added back to the value of “free cash flow”, while tax breaks for interest expenses are taken out:

Unlevered free cash flow = free cash flow + interest expenses - tax deductions due to interest expenses

Note that tax deductions due to interest expenses may not appear in the cash flow statement nor the income statement, and may have to be estimated.

Free cash flow essentially tells us “how much this company can return if we just run it ‘into the ground'”, i.e.: without replacing consumed capital assets. It is a base case of what profits the company is capable of extracting from its businesses.

Unlevered free cash flow is similar, and gives us an idea of what free cash flow would look like, if an acquirer buys out the company and pays off all its debts.

There are other variants of free cash flow that are sector specific. The most widely used is “funds from operations”, which is used commonly in real estate heavy companies (such as REITs). “Funds from operations” is just unlevered free cash flow with losses and gains from sale of properties removed, i.e.: gains are taken out, losses are added back in. The idea is similar — to try and get a number that gives us an idea how profitable this company can be, purely from its core operations.

Once we have determined the variant of free cash flow we are using, and have computed its value, the next question is, what do we do with this number?

Recall that free cash flow gives us an idea of the core efficiency of a company at its businesses. So the most common thing, is to look at free cash flow over time. Is it consistently going up? Is it growing at a suitable rate based on investments into the businesses? How much is the shareholder paying for each dollar of free cash flow?

Ideally, we want free cash flow to be increasing over time, and at a pace equal or faster than reinvestment rate — if the company is reinvesting profits equal to 20% of capital assets, then free cash flow should increase by 20% or more in subsequent periods (2). Otherwise, the company would probably be better off investing that money in other pursuits, or returning the cash to investors.

Sometimes, an unprofitable company may be a good investment, even if free cash flow is currently negative! A company that is heavily investing in its businesses may sometimes have negative free cash flow — recall that free cash flow is operating cash flow – capital expenditure. Assuming the capital expenditure is a temporary event (3), when the need to invest in scaling the business stops, free cash flow will likely quickly jump to positive. Note that such businesses are not without their risks! There is a chance that the capital expenditure does not result in future profits, for example, if the research failed to find anything useful, etc.

Finally, the price / free cash flow (P/FCF) ratio is a useful indicator of how much the investor is paying for dollar of free cash flow from the company. As with the other price ratios (P/E, P/S, etc.), the numerator is usually the market capitalization (price per share can also be used if free cash flow is also normalized to free cash flow per share).

Like the P/S ratio, the P/FCF ratio may be useful for informing whether a company is a good investment at a certain price, even if the company is currently unprofitable. Furthermore, the P/FCF ratio is also useful for companies that have strong and stable cash flows (such as some real estate related businesses) — unlike the P/E ratio, the P/FCF (or P/FFO — price per funds from operations) tends to provide a more stable value less affected by one time events that are not related to the core operations.

A company with a good P/FCF ratio, but a terrible P/E ratio may simply be affected by accounting quirks like depreciation and amortization rules, which are not strictly part of the core operations.

Footnotes

1. I kid! Nowadays, every financial statement pushed out by a public company, especially a large, public company, is scrutinized by an army of analysts whose jobs are, in part, to make sure silly arithmetic mistakes are rooted out. The additional lines are still useful for those who are curious, and want to know the breakdown even more, though.
2. Note that in some industries, there is a significant lag time between when investments are made, to when profits from those investments can be extracted. This should be taken into account when judging if free cash flow is growing at a rate commensurate with the investment rate.
3. Many types of businesses are characterized by heavy capital expenditure in a few years, followed by many years of extracting profits from those capital expenditures. For example, research and development heavy industries (pharmaceuticals, some technology firms, etc.), manufacturing industries (building factories, etc.). Once the capital expenditure is done, the company may be able to enjoy many years of profits without having to do more capital expenditure.