Arguably the world’s greatest investor, Warren Buffett says that you should value a stock as you would value a private business. In the private sector, P/E means nothing. In fact, earnings mean nothing. The only thing that matters in buying a private business is the amount of cash that it can generate-its free cash flow.
When you buy a stock, you are buying the company’s net worth and a right to the cash that the company can generate in the future. Earnings and revenue are numbers reported on the company’s tax return and mean nothing to a business owner or investor. You can’t spend earnings to grow the business-you can only spend the cash that makes it to the bank after all expenses are paid.
If you know the net worth of the company (the Shareholder Equity) and you can reasonably estimate the future cash of the business with a degree of confidence, you can quickly figure out the true value of a business. Once you know the value, you should insist on buying the stock at a discount to its value. (The discount is a Margin Of Safety so that you still earn attractive returns if the company does not produce as much cash as you had expected.)
Only when the stock price is at or below your Margin Of Safety should you consider investing. Interestingly enough, investing in this way produces three unbelievable results:
- It would tell you to buy Johnson & Johnson at $62.33 a share in 2007 – right around the price at which Warren Buffett was buying earlier this year;
- It would have protected you from the Lucent, Enron, and Worldcom scams because free cash flow is hard to fake – even when earnings and other tax return numbers are growing; and,
- It will allow you to invest with confidence and check in on your stocks once a year. Buying businesses as a business investor gives you the confidence and comfort to know that you own wonderful companies at attractive prices and that you do not need to concern yourself with the daily silliness of the stock markets because, over time, as your company’s value grows, its stock price will have to follow.
Filed under: How to Think About Stock Prices
Related Stocks: JNJ
Hey John,
There are two ways to determine Free Cash Flow:
1) You can find it on (a few) financial websites. I like Morningstar because they already calculate the Free Cash Flow for you. Look up a company and head to their “10-Year Cash Flows” section under “Fundamentals.” Free Cash Flow is listed at the bottom.
2) You can calculate it by looking at the Statement of Cash Flows for a business – one of the three financial statements (the other two being the Balance Sheet and the Income Statement). On the Statement of Cash Flows, you can calculate the Free Cash Flow by taking the Net Income plus Depreciation and Amortization minus Net Additions (Subtractions) of Plant, Property, & Equipment.*
In any event, that Free Cash Flow calculation will tell you if the business can grow or survive on its operations alone or if it has to rely on other sources of cash to pay its bills.
These numbers come right from the company’s bank statements. Earnings are easily manipulated. Cash is very hard to fake.
Hope that helps!
Edit: July 18, 2007: Sorry folks, I had given you the wrong calculation. I changed it (above) to accurately reflect Free Cash Flow (aka, Owner Earnings). I use the above formula; however, I had typed it wrong prior to this edit. Sorry for any confusion!
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Joe,
It would be of great help if you posted an article on how to treat variations in free cash flows e.g of you have a company that is generating huge cash but is also reinvesting heavily e.g Walmart; FCF will be low for recent years but future FCF’s will be higher as the investments pay offs or where recent free cash flows are much lower than history e.g IBM
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Joe,
Good article, but I think a better (and easier) solution to obtaining FCF from a cash flow statement is to take “Cash flow from Operations” and subtract “Investments in Plant Property & Equipment”. You will also see this listed as CapEx for many firms (to use the example of JNJ on Morningstar).
A firm that is growing over time will need to invest in working capital (inventory, accounts receivable,etc.). Taking Net Income and adding back depreciation misses this.
I think you’ll find that Morningstar also calculates FCF in this manner.
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Hi Mark,
Yours is the original formula I posted in my comment. When it comes down to it, you can use either one – so long as you are consistent. Using the formula I posted gives you the raw FCF – without any corrections for stock options, tax benefits received, or other non-cash charges. It is essentially the FCF if the company was stripped down to its bare operations.
Then again, how likely is it that management will give up the stock-based compensation? Your formula, and the one I had originally posted, gives us the “Silent Partner Earnings” – the free cash flow we little guys have to accept because we have no say in the operations.
In Calculating The Value Of A Business – Part II (coming tomorrow), I am going to discuss the two methods and talk about which one I like. Rest assured, I generally prefer and use the one you mention – the “Silent Partner Earnings.”
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Manish,
No. The cash flow is how much cash the business’ operations generated. The cash and cash equivalents, though an asset of the business, were not necessarily generated by the business’ operations in that particular quarter or year.
Cash and cash equivalents can come into play when valuing a company, but not when calculating free cash flow or owner earnings.
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So how do you calculate free cash flow? Is this number (FCF) based on hard numbers that one will find on the balance sheets published on financial websites?
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