Welcome to our Value Investing 101 series. In Part 1, I explained what the “intrinsic value” of a stock is and in Part 2, I explained the math we need to calculate intrinsic value. This week in Part 3, I’ll cover what “cash flow” actually is .
Review: What is Intrinsic Value and How Do You Calculate It?
According to Warren Buffett:
Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
So how do you discount the value of the cash that can be taken out of a business during its remaining life? You run a DCF analysis, projecting out the company’s cash flows for a number of years and then discounting those cash flows back to the present value using some discount rate.
Your DCF analysis might look something like this:
You could then use the intrinsic value you calculate and decide to buy the stock ONLY if the company’s market price is LESS than its intrinsic value. Note: If these concepts still seem fuzzy to you or if you missed my other articles, then please go back and read Part 1 and Part 2 before moving on.
But what do we mean when we talk about a company’s “cash flow” anyways, and how can we project it?
Free Cash Flow
When we say cash flow, what we’re really talking about is Free Cash Flow.
Free cash flow is the amount of cash that a business generates that is available for distribution to all of the security holders of that company, including both debt holders and equity holders.
There are multiple formulas to calculate Free Cash Flow (“FCF”). Here are the most common ones:
FCF = EBIT x (1 – Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditures
FCF = Operating Cash Flow – Capital Expenditures
FCF = EBITDA – Change in Net Working Capital – Capital Expenditures
Non-Cash Items, Changes in Net Working Capital, and Capital Expenditures
No matter which formula you use, FCF incorporates three major items.
First, FCF starts with the “profits” of the company (whether that is EBIT, Net Income, or EBITDA) and adjusts for all non-cash items (like depreciation and amortization) to determine the “cash profits” of the business.
Then FCF adjusts for changes in net working capital. Net working capital is Current Assets (not including cash) minus Current Liabilities. Current Assets includes things like accounts receivable and inventory, and Current Liabilities includes things like accounts payable. If working capital increases (e.g., the company invests in inventory, accounts receivable increases, or accounts payable decreases), then this is a use of cash; if Working Capital decreases, then this is a source of cash.
Finally, FCF must account for the company’s investments in its long-term assets, includings its Property, Plant, and Equipment. This is called the company’s Capital Expenditures.
Warren Buffett’s Owner Earnings
Warren Buffett essentially runs a DCF to determine a company’s intrinsic value, but he uses what he calls “Owner Earnings”, which is a slight variation on Free Cash Flow.
Warren says this about Owner Earnings in his 1986 Berkshire Hathaway Shareholder Letter:
If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”
Okay. So Buffett’s Owner Earnings is basically the same exact calculation as Free Cash Flow, except he determines intrinsic value by looking at the company in a “no growth” situation.
Warren essentially views a company as a bond with an annual interest payment and says, “If I owned this company today, and if revenue never grows and margins stay flat, and if the company only invests as much as it needs in marketing and PP&E to keep its current position, then how much Free Cash Flow could the business consistently generate on an annual basis?”
In other words, Warren Buffett’s Owner Earnings is just Free Cash Flow in a 0% growth scenario.
In a 0% growth scenario, changes in net working capital would be 0, because sales aren’t growing so accounts receivable, inventory, accounts payable, and other current items remain flat. And capital expenditures would be equal to just “maintenance capital expenditures” (an item that we would have to estimate), because “growth capital expenditures” would be equal to 0. So:
Owner Earnings = EBIT x (1 – Tax Rate) + Depreciation & Amortization – Maintenance Capital Expenditures
Next Time in Part 4: How to Project Owner Earnings
In Part 4 of this series, I will finally tackle how to actually project owner earnings to determine intrinsic value, and I will provide an example by calculating the intrinsic value of a real company.
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