I’m just getting caught up on the slew of comments here and I wanted to jump in again on this string over on What The Heck Is CROIC? There seems to be some confusion as to how free cash flow and GAAP earnings are related and I figured that this would be a good topic rather than let it get buried in the comments.
Do GAAP earnings drive free cash flow? Or, does free cash flow drive earnings?
The Accounting
Businesses can have very complex accounting practices. Still, whether you are looking at business finances or personal finances, the basics are the same. No matter what you report to the IRS-no matter how good (or bad) you look on paper-you or your business will financially survive, thrive, or die based on how much cash you can generate.
Let’s break down a simple example of how dollars flow through a fake business:
- Company spends $20,000 marketing its consulting service.
- $200,000 flows into the bank because customers paid for consulting services.
- $100,000 (50% of revenue) is spent by the company on utilities, salaries, etc.
- $80,000 is left in the bank at the end of the year.
Uncle Sam† Wants His Cut
Tax time. Our business has to file its return. What wasn’t shown in the above is a “depreciation” expense-a write-off that the company is allowed to take based on a prior purchase of equipment. For the sake of simplicity, let’s assume the company won’t have to re-buy or replace that equipment for the next two or three years.
On its tax return, the company shows:
- $200,000 of revenue,
- $120,000 of expenses that required cash,
- $20,000 of depreciation-even though it didn’t require cash and doesn’t appear in the above report.
As far as Uncle Sam is concerned, our business had a taxable income of $60,000. In the US, this company would pay $10,000 in taxes (2006 rates) leaving it a net income of $50,000.
Net Income Vs. Free Cash Flow
To calculate free cash flow, we have to follow the cash. In practice, we simply add that depreciation back in to the net income (along with some adjustments). In reality, the actual free cash flow calculation would start with revenue and subtract any cash expenditures:
- $200,000 of revenue
- - $120,000 of cash expenditures
- - $10,000 of taxes paid in cash
For this company, free cash flow would be $70,000 even though net income reported to shareholders and the IRS was $50,000.
Question: What Drives What?
Does free cash flow drive earnings? Or vice versa? Here’s the reality: No matter what the earnings were for the year-no matter how creative or conservative the company was with its accounting-this business has $70,000 in cash that it can use to grow.
What will it do? Well, we saw that it previously spent $20,000 on marketing to generate $200,000 of revenue. Assuming it wanted to (and could) repeat that performance, the business would invest that full $70,000 in marketing to generate $700,000 in revenue-assuming it was that easy!
Answer: Free Cash Flow Drives Earnings
A year passes, and our business used that $70,000 for marketing. Here’s how the year played out:
- Company spends $70,000 marketing its consulting service.
- $700,000 flows into the bank because customers paid for consulting services.
- $350,000 (50% of revenue) is spent by the company on utilities, salaries, etc.
- $280,000 is left in the bank at the end of the year.
Again, we pay the piper. After deducting another $20,000 in depreciation, Uncle Sam collects $84,650 in taxes. Net income comes in at $175,350; free cash flow is $195,350.
The Key Is Cash Flow
Why did earnings increase? Simple: The company generated enough cash to fuel earnings. Had our business only generated $20,000 in excess cash, it would have only had $20,000 to spend on marketing and we could have only expected around $200,000 of revenue (or a $200,000 increase depending on whether or not past customers were buying again).
Creative Accounting
Yes-businesses can mess with their accounting to look better or worse than they are. Still, no matter what our business did to its tax return figures and net income, it had exactly $70,000 to fuel growth. Could the executives have stolen that cash and screwed with shareholders? Perhaps. Still, if that is the number one reason you are scared to buy stocks, you certainly shouldn’t be in the markets in the first place.
†Non-U.S. readers: Uncle Sam is a reference to the US Government and/or the US Internal Revenue Service (IRS).
Filed under: How to Value a Business
Hi Joe,
Your blog is excellent. However, I have reservations on this post.
In the long run, shouldn’t the earnings equate to FCF if there are no dividends?
If so, we should not theorectically prefer FCF or earnings over the other.
While FCF may drive earnings, companies can also borrow to drive earnings, especially property developers.
I would suppose that people prefer free cash flow nowadays is probably due more to accounting issues as it is easier to fudge earnings than cashflow.
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TNL,
Yes, theoretically speaking, net profits, which you are referring to as “earnings”, should equate to FCF over time. However, we don’t live in a perfect world, and as such, slightly more analysis will always need to be done than just relying on net profits. Other than the most obvious reason for “earnings” not being reliable (earnings are easy to manipulate), there are many other significant reasons not to trust the reported earnings. Obviously, depreciation is a non-cash charge against earnings, and if a company is growing, that means they’re investing cold hard cash into a lot of new assets, and this will not show up in the reported earnings, as only a portion of the new assets are charged against the period’s earnings. Also, management are the ones that determine when a sale is recorded. Even though many companies stick to the same method over time, occasionally you’ll find management that for whatever reason (and there are some legitimate reasons) feels the need to change when a sale is recorded. This has a big effect on cash flow. If a lot of cash is tied up in inventory, or accounts receivables, or it they have a significant amount of accounts payable, this too will effect cash flow and “earnings” in different ways.
Just keep in mind, you have to seperate what constitutes “net profit” from real cash flow. This takes more effort, but will give you the true picture. And remember, trends take longer to develop, which is why Joe stresses so heavily to use at least 5 – 6 years of data.
Hope that was somewhat helpful.
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I’m curious, Joe (or Nick, your alter-ego 
); How do you guys typically derive your FCF numbers? I’ve seen a few different methodologies, but the big two seem to be either taking reported Net Income and adding back non cash depreciation & amortization, or starting with OCF and subtracting average annual maintenence cap-ex. Once again, theoretically, the numbers should be the same over time, but I’ve found that there can be some radically different results.
Thanks for shedding some light.
-Jeff
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Joe:
I am sorry to comment that you are making it harder than it is. Also, there is a major flaw in your argument — please see the post-post script.
A simple proof that earnings drive free cash flow is to take a clean example and assume you started up a new business. At the end of the year you generated $50,000 in earnings and free cash flow of $35,000. Let’s say you closed your door the next day because you realized $50,000 is insufficient to stay in business. Since it was a start-up, it’s easy to show free cash flow CANNOT drive earnings. This is enough proof to completely sink your argument.
Second you are confused about financial statement logic in two main ways: (a) “earnings” and “quality of earnings” as they are not the same. There is a cash flow concept called dual cash flow and (b) cash flow timing.
With respect to (a), there is a concept called dual cash flow and the “shorts” used to this to help identify financial shenanigins. This theory claims that there should be a positive relationship between net income (earnings) and cash flow from operations (the difference being non-cash charges and items that affect working capital accounts). There is a huge red flag if a company generated positive earnings but has negative cash flow from operations. This is a very important point because under the Joe Ponzio school of free cash flow, a company can simply use vendor financing (I already pointed this once in a Wal-Mart thread) and augment its free cash flow. This is patently absurd because there are limits to vendor financing, but investors who follow Joe will have artificially inflated free cash flow numbers because their cash flow from operations would be artificially inflated.
With respect to (b), there is a need to understanding the matching concept. This year’s earnings drive this years free cash flow. If a company generated a net loss for the year, it would not be a surprise to free cash flow under duress ceteris paribus. If the company’s earnings was positive, its free cash flow will be enhanced ceteris parabus. Again, earnings drive free cash flow.
Last point. Before the FASB 95 pronouncement, it was very difficult to calculate free cash flow because one of the financial statements reconciled to working capital, not cash. However, investors like Warren Buffett was using a concept he called “owner’s earnings*,” which is very similar to free cash flow. Also, if you had worked in commercial lending, there was the RMA UCA approach, which is very similar to the current direct approach. That is to say it was possible to discern free cash flow prior to FASB 95 and in all cases (inclusive of Buffett’s owner’s earnings definition), one starts the free cash flow calculation with (as you guessed) earnings.
Cheers
* PS if you research Buffett’s owner’s earnings definition, then you would realize he makes adjustments for working capital accounts (which you don’t) and normalizes capex (you don’t do this step as well).
PPS Major flaw in Joe’s example. How did the company obtain assets in the first place to create the $20,000 in depreciation?? If the company had purchased the assets, cash in the bank had to be reduced to reflect this purchase. If the assets were acquired with a loan, then where is the interest expense. These are examples of financial statement logic. That is why it is best to use a start-up business since it has the cleanest financial statements to work with. … However, the deferred tax expense Joe uses doesn’t change the fact the free cash flow calculation begins with earnings and hence earnings drive free cash flow.
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Addendum, in case people want to learn more about the “Dual Cash Flow” concept:
http://www.aaii.org/stockscreens/allcharts.cfm#dualcashflow
http://www.spredgar.com/dual_cash_flow.htm (if you want to see the steps, again this is just one approach).
http://www.businessweek.com/1996/32/b348784.htm (this is just one example of dual cash flow)
When I first learned the dual cash flow concept, it was about identifying a company that was stuffing the channel, i.e. sales increased and earnings increased correspondingly but I saw massive jumps in A/R and sometimes Inventory levels (there’s typically a lag in inventory because it builds once finished goods can’t be sold). I used a metric called Funds from Operations (typically used in debt analysis per S&P), which is an intermediary step between earnings and cash flow from operations and I would observe the sudden reversal of cash between Funds from Operations and Cash flow from operations. Again, these are concepts that a short would be focused on because it was clear the quality of earnings was suspect — if earnings were suspect, then free cash flow had to be suspect (under the rubrik of earnings drive free cash flow).
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Casey Mattson stated: “In truth, yes you “calculate” FCF from the GAAP earning and balance sheet. But that does not “drive” FCF. Not the same thing.”
This a logic or thought experiment for people like Casey Mattson et al. Here, I will use a simple ceteris parabus example to show the existence of cause and effect aka causality.
First let’s agree that FCF is net income plus non-cash items plus working capital account items plus capex per FASB 95 (where a line item is positive means it was a source of cash and when a line item is negative, it consumed cash). The math is easier with addition — note adding a negative number like capex lowers the FCF number).
Second, let’s create a scenario where a company was running in a steady state, i.e. depreciation was identical to capex, and thus is a wash. Also, the working capital account neither generates or consumes cash.
In summary, in this example, net income is identical to free cash flow. That is to say, I’ve clearly shown net income drives free cash flow, i.e. the cause and it’s effect. This isn’t about semantics or accounting pronouncements, it’s about financial statement logic. For example, let’s say the company experienced a sudden windfall and sold an asset for $100 in additional profit. Because earnings increased (ceteris parabus), higher earnings drive higher free cash flow (the marginal impacts are taxes as proceeds exceeds basis and backing out the gain on sale of asset which is non-cash in nature, etc — please note the recognition of the cash from the sale of asset is an investing, not an operating, activity). Conversely, if the company experienced a non-recurring expense that led to lower earnings (ceteris parabus), then it would not be a surprise to see a correspond lower free cash flow number. I’ve already shown you the steady state; thus, in all possible outcomes under this thought experiment, earnings DRIVE free cash flow because there exists causality amongst these two factors. Whatever the starting point of earnings, it will have an DIRECT impact on free cash flow.
Cheers.
PS I’ve taught this concept to MBA interns in my prior firm and many just get the initial concept and very few get the true message. Recall that I stated before Professor Fried taught me to understand both the accounting results and to compare it with the economics. Therefore, the correct approach was one where it didn’t matter where you use accounting numbers or economic numbers because both approaches should get you to the same place if you did it correctly. That is why Buffett’s owners’s earning definition makes sense at both the accounting and economic level. In contrast Casey Mattson and Joe Ponzio et al are arguing the issue solely at the accounting level, while ignoring the economics — again, what the accountants tell the readers as the accounting earnings MAY NOT BE REFLECTIVE of the economics. For example, vendor financing (something Joe Ponzio doesn’t make adjustments for) is an accounting phenomenon and should have NO IMPACT on the firm’s free cash flow on an economic basis. One more time, if earnings is suspect, then free cash flow is suspect; to get the correct free cash flow number, one has to get the “correct” earnings number and why I harp on earnings drive free cash flow.
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Chungst,
I understand what you are saying about earnings because free cash flow is a derivative of earnings just as earnings are a derivitive of revenue. I’m not an
expert on accounting but I think that you are really in agreement with Joe.
A start-up not withstanding, I’m thinking that by using several years of data points smooths out the changes in vendor financing and changes in inventory by adjusting the growth rate so even if you start your analysis with a higher free cash flow number because of vendor financing and lower inventory your intrinsic value will be adjusted lower because of a lower long-term growth rate. Also I think it would be more helpful if you use less personal accusations in your posts because it does have a distracting effect on the very intelligent points that you make.
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Dear Anonynmous:
You stated: “I think that you are really in agreement with Joe.”
First, Joe and I are NOT in agreement. Second, these personal accusations are fact-based (thus it is fair game) and forms the basis of why Joe and I can have an intelligent conversation or disagreement.
Joe acknowledges that he uses a simplified approach to get to FCF, and by construction he must acknowledge the limitations, i.e. some of those are Joe’s limitation of not normalizing certain events. If Wal-Mart gets $1B in vendor financing, via a $1B increase accounts payable, to increase its cash flow from operations, it begs the question why should investors be will to pay a multiple of that one-time vendor financing. That entire $1B should not part of FCF on an economic basis because it was a timing event.
Then you stated: “I’m thinking that by using several years of data points smooths out the changes in vendor financing and changes in inventory by adjusting the growth rate so even if you start your analysis…” It doesn’t smooth out because you are discounting these cash flows and the general rule is cash flow in the near term has more weight than cash flow in the later periods. I’m sorry, but your claim is PATENTLY incorrect.
I believe Joe welcomes a honest debate about this topic because people will have more information to form their own views. When Joe highlighted my original message, I made it clear that he’s methodology has a weakness in that it uses accounting numbers. I still stand by that claim.
Regards,
Chungst, not an “anonymous” poster.
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Chungst,
You stated: ” these personal accusations are fact-based (thus it is fair game) and forms the basis of why Joe and I can have an intelligent conversation or disagreement.”
I don’t want to get in a spitting match with you but I couldn’t disagree more that personal accusations are by definition not on opinions or behavior but on character and subtract from any facts that you present. Your defensive “diggs ” do not just pass by reader’s attention and really points more to your character
than anything else. Joe has done a a lot for us and we all appreciate his honesty and his patience.
You also stated: “It doesn’t smooth out because you are discounting these cash flows and the general rule is cash flow in the near term has more weight than cash flow in the later periods.” I agree that near term cash flow has more wieght than projected cash flow but I also think that past growth rates of cash flows have a greater weight on intrinsic value than on current cash flow. You should definitely look at your starting number if it is way above the usual increase in cash flow from the last period. Have a nice turkey day!
Regards
Anonymous
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Dear Chungst,
I kind of understand where you’re going with your logic, however in order to understand this more clearly, would you be able to clarify and provide references for your process.
How do you calculate FCF? (Details please, provide a complete example or provide a reference where it’s given in entirety.
Regards,
Sanjay Shetty
I blog at http://indiainvestor.wordpress.com
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Chungst:
When and how did I say I was ignoring economics?
This process is first and foremost a “test” to see if a company passes a basic valuation analysis. Then the real work begins. Reading financials, assessing management, and the overall economics of the industry and the company.
As for Buffett and his assessment of owner earnings, I have heard him say (meaning read in his annual reports): when he has purchased private companies, he needs 10 years of financials, and 15 minutes to see if it is a business worth buying and the sellers have one shot at naming a mutually beneficial price. Does this sound like someone who has an overly complex model to analyze a company? I understand that he is certainly more intelligent a business person than I, having said that, I don’t think you need to go into such tremendous detail on your initial valuation.
You are obviously a very intelligent person yourself. Buffett has also said a high IQ is not necessary to be a great investor, and sometimes it is a barrier to success. Meaning smart people tend to overthink the investment decision. No disrespect, but I do believe you are “overthinking”.
I also wonder what the heck your intent is in coming on to this website, professing your viewpoints, over and over again, when as a basic principle you agree with nothing on here. If nothing other than to show people you know FASB and GAAP rules, attempting to discredit Joe, what are you REALLY trying to do? I would, as would others I am sure, appreciate some perspective from you.
Also for ripping on “Anonymous”, you sure have not given anyone your name. Please do, so we can see who you really are.
Everyone else, have a great Thanksgiving
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Chungst,
In your “simple example”, you assume the business shuts down. Free cash flow drives future earnings. If a business shuts down, there are no future earnings and you would be right. In fact, when you expect your business to shut down, it is worth nothing more than its break-up value. When investing in ongoing businesses, however, your simple example doesn’t discredit the discounted cash flow method at all.
You said,
Since it was a start-up, it’s easy to show free cash flow CANNOT drive earnings. This is enough proof to completely sink your argument.
You can not value an ongoing business the same way you value a breakup.
You also stated,
This year’s earnings drive this years free cash flow.
This year’s earnings can be used to calculate this year’s free cash flow. Still, next year’s earnings are driven by this year’s free cash flow. No free cash flow? The company will have to beg, borrow, or steal to get the cash it needs to grow (or survive). It is that simple – and it is a fundamental basic of business no matter what the books and other theories say.
If the company’s earnings was positive, its free cash flow will be enhanced ceteris parabus.
Using that logic, Lucent, Enron, Worldcom, et al would have looked very attractive as they went from positive earnings and excess cash to positive earnings and negative cash in the late nineties. No matter what the off-balance sheet arrangements were, free cash flow told the true story. Earnings were sales tools for Wall Street.
You said,
if you research Buffett’s owner’s earnings definition, then you would realize he makes adjustments for working capital accounts (which you don’t) and normalizes capex (you don’t do this step as well).
Take a look at my valuation method and you will see that I take into account changes in the balance sheet to get a true picture of free cash flow. If your arguments are based on the idea that I simply add depreciation and capex into the equation – without accounting for balance sheet changes – I invite you to go back and read some of my posts on this blog.
As far as the “major flaw” in my example, I provided a simple example of an ongoing business – the types of business in which 99% of stock investors will make 99% of their investments. Valuing start-ups and break-ups are different.
You then presented a theoretical situation in which net income and free cash flow were identical over the long term. (TNL: here’s your answer too) Over the long term, many theorize that net income and free cash flow are the same. Not true. The reality is this: Over the long term, depreciation should equal capital expenditures (that’s the confusion point). Because free cash flow takes into account changes in the balance sheet and net income does not, net income and free cash flow may not be equal over the long term.
In your theory Chungst, you assumed that there were never any changes in the balance sheet. In that nearly impossible and theoretical company (and only then) would net income equal free cash flow.
You seem to have a good basis in theory. I would invite you to speak with some seasoned business owners and accountants to see how business finances and operations work in practice.
Do I tend to make things easy? Yes. Then again, valuing a business generally is. The hard part is predicting the future.
Happy Thanksgiving!
Joe
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Joe,
I just have to say a word or two about this discussion.
First, I love it. It makes great reading.
Second, while careful thinking is critical to any investment decision, the concept that refining the inputs to a very imperfect model improves the results is seductive, but wrong. Your model has so many guesses, intuitions and approximations that to think of it in precise terms is highly misleading and misses the point. Mr. Buffett is not known for being the greatest accountant in the land, but for his common sense and business insight.
You are right. Predicting the future is what it is all about, and as a great philosopher said, “The future ain’t what it used to be.” (Yogi Berra). Think about that one for awhile.
I highly recommend Nassim Taleb’s book “The Black Swan” as an antedote to this line of thinking.
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As others have mentioned, I think the initial posting on this topic is incomplete without discussion of Net Working Capital and Cap-Ex. Also, there should be a distinction made between free cash flows to the firm (FCFF) and free cash flow to equity (FCFE). FCFF is discounted by WACC to give firm value, from which total debt is subtracted to arrive at equity value. FCFE is discounted at the cost of equity to arrive at the value of equity.
FCFF = EBIT(1-t) – (Capital Expenditures – Depreciation) – Change in non-cash Working Capital
FCFE = Net Income – (Capital Expenditures – Depreciation) – Change in non-cash Working Capital – (Principal repaid – New Debt Issued)
As for the question of whether earnings drives cash flow or vice versa, it seems a rather circular chicken-egg type argument to me. Both are measures of a firm’s profitability and for both the key drivers are revenue and operating margin. Where cash flow and earnings diverge has to do with the relationship between depreciation and actual cap-ex, between the provision for taxes and actual cash taxes, and also with net working capital investments which do not impact earnings but do impact cash flow. Shenanigans occur when firms use accounting maneuvers (like releasing reserves, or booking costs as a pre-paid expense (asset)) that enhance earnings. Those maneuvers do not effect cash flow which is why keeping track of cash flow and its relationship to earnings is so important.
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Hello all,
first of all Joe, thanks for your brilliant blog, for the first time in my (still young) life as an investor I am quite confident that I have a good framework to make my decisions.
I have a question though about how to calculate FCF from the consolidated financial statements. Suppose you have the following example:
Net income
27,951 23,559
Items not impacting on operating activities cash flow:
Depreciation and amortization (excluding current assets)
1,591 1,125
Movements in deferred tax
(569) (313)
Cash flow from operations
28,974 24,371
Working capital items movements:
Accounts receivable
(48,332) (5,399)
Accounts payable
27,225 4,312
Inventories
(21,919) (21,997)
Other
(3,371) 1,859
Minority interest share of subsidiaries%u2019 net income
283 142
Net cash provided from/(used in) operating activities
(46,114) (21,083)
Would you calculate the FCF, and thus subtract Capex, from the last row (net cash provided from/used in operation activities), or would you the ‘cash flow from operations’? Especially for a company with a massive inventory, like this one, it makes a serious difference (between positive and negative FCF).
Any help would be seriously appreciated, as a European investor (investing in European companies), unfortunately, you have to dig a bit harder to find the data, since Morningstar is not much help in this case…
many thanks,
Bart
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Joe,
This is a late post… I hope it gets on here. Anyway – love the site, very Buffett-like info and very accessible. I am convinced that cash is king and GAAP earnings really don’t mean much.
I’m still trying to wrap my mind around FCF and how it relates to me as an investor, though. If I own 1000 shares of X company, and it steadily produces FCF growth of 15% per year, the company is doing well, but I really don’t see FCF in my pocket, but I DO see dividends and price appreciation (when/if I sell, of course). Furthermore, FCF doesn’t take into account debt and other investments the company may make. Management could take “my” FCF and invest it into a losing security, rack up a bunch of debt, and I won’t ever see that FCF. So my question is, why do I need to focus on FCF when only dividends actually make it into my pocket?
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Shortly after posting the question above, I got my answer. I am reading “Common Stocks” right now and Fisher answered it for me in his chapter about the Hullabuloo about Dividends. I now know that the dividends I get in my pocket can not be re-invested by management into a worthy cash-generating endeavor. If I forgo dividends now and management retains earnings to grow the business, this will obviously translate into future gains, and price will follow value. I get it! I guess that’s why management’s acumen is important to look for.
Eliot
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Thank you Joe for the post and facilitating an environment for healthy investing discussion. I believe this post alludes to the importance of having a stock valuation framework that is consistent with thinking like a business owner. Like Joe, I believe a focus on free cash flow is paramount to thinking like a business owner. However, I believe that Chungst’s conclusion that earnings drives free cash flow has merit. My discussion below will focus only on an all-equity firm as it will make things easier but the analysis can be generalized to firms with debt financing.
To avoid confusion, a concrete definition of free cash flow is in order. The free cash flow equation below starts with the free cash flow formula given by Bosco’s post but is decomposed into maintenance and growth components.
Free cash flow = EBIT(1-t) – (Capex- Depreciation) – Change in non-cash
Working Capital
=EBIT(1-t) depreciation – maintenance capex –change
in maintenance working capital – growth capex – change in growth
working capital
=operating income – change in maintenance net operating assets
– change in growth net operating assets
=owner’s earnings – change in growth net operating assets
Note that this definition is similar to Warren Buffett’s except extended to include growth expenditure and does not use average capex like he does. Of course, it may be advisable to use average capex to smooth out numbers but I want to keep things simple for exposition.
There are two top level factors that affect owner’s earnings: operating income and investment rate. Investment rate is the minimal level of investment required to maintain the firm’s competitiveness a la Warren Buffett. In theory and all practicality, owner’s earnings is what business owners really care about-how much money can I withdraw from the business without affecting its competitiveness? Viewed in this way, free cash flow does not affect future earnings. Future free cash flow will be driven by future profitability of current investments (future earnings) and future investment decisions. Ultimately, what drives earnings is the firm’s profitability of investments, not free cash flow. One may say that free cash flow is what provides resources for growth in earnings, as Joe’s example attempts to show. However, it is incorrect to say this because free cash flow is the result of operating and investment decisions. Although free cash flow is what ultimately matters, it is the operations and investment decisions of the firm that provides free cash flow. So it is earnings, which GAAP tries to approximate, along with the investment rate that drives free cash flow.
From my reading of the comments, I sense that many people are skeptical of GAAP earnings, as they should be. Although GAAP earnings are subject to manipulation and judgment, I believe the income statement should not be ignored. Analyzing the quality of earnings on the income statement gives insight into the integrity of the management. Also, the income statement in conjunction with the balance sheet gives better insight into the value creation process than the cash flow statement.
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Howdy:
Brand new here…just bought the book a week ago and I am banging away at the excel spreadsheets trying to understand how it all works.
As part of figuring it out, I try to go back and see if the way you teach follows the way Mr Buffet actually bought. A more recent purchase by Mr Buffet has me confused.
He recently bought Republic Services Group. As far as i can tell, he and Mr Gates are buying up shares in this company like crazy. Yet, the cash flow for these guys is all over the map and sometimes quite often negative!!!
Add for awhile the shareholders equity is fairly flat and then jumps like crazy in the last couple years and it leaves me totally confused as to how to figure out the value of this company going forward and how Mr Buffet and Mr Gates have decided to buy up so much of it.
i guess the numbers are skewed due to the recent merger/acquisition of Allied Services.
Can you comment on how you would approach putting a value to a company like this which has free cash flows that are negative and then equity and liabilities that shoot through the roof in one year? If Buffet is buying, you would think it has to be a good idea, but I can’t see how to value it…
Thanks
Love the book
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Nicely done!
I was very surprised when one of the posters said GAAP earnings drive free cash flow. In truth, yes you “calculate” FCF from the GAAP earning and balance sheet. But that does not “drive” FCF. Not the same thing. He was very well versed in FASB rules, which are all fine and dandy, we CPAs find comfort in those things some times. But business evaluation, in spite of all the GAAP rules, still gets down to cash, and cash still drives your business.
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