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

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.

You nailed it.

Eliot

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?

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

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.

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.