Saturday, August 15, 2009

The Numbers Game: How To Read Financial Statements (The Cash Flow Statement)

The last part making up the financial statements is the cash flow statement. It simply shows the actual cash flowing into and out of the company. You may now know that the balance sheet reveals a company's assets, liabilities and shareholders' equity at the close of a given period or fiscal year. The income statement shows the changes that have occurred in the balance sheet items, including the promises of money that the company has made or received. The cash flow statement differs in that it reveals the changes in actual cash that the company has generated and raised through creditors and investors. It also shows how the company invested the cash between the start of one fiscal year to the end of another. In other words, the cash flow reflects where the money comes from and goes to.

The cash flow statement comprises of three parts, namely, cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
  1. Cash flow from operating activities: It shows the money that comes in from sales of the company's products or services and the money going out to produce those sales. It also includes interest and tax payments. Under GAAP, it allows revenue to be recognized on the income statement before actual cash or payment is received. But not so on the cash flow statement, which lists only revenues actually collected or received. Thus, you may see negative cash flow from operations. On its face, this may seem like a bad omen, but it isn't always a signal to sell. Fast-growing start-ups will tend to show negative cash flow because it consumes more cash than they can generate in the first few years of the business. They cover the shortfall by borrowing money or issuing stock. However, at other times, negative cash flow may indicate a company is in trouble, especially if the company is disposing of assets or selling pieces of the business, because it cannot persuade investors to buy its stock or credit market to lend it money.
  2. Cash flow from investing activities: This is where the company reveals the amount of free cash flow and how it's utilizing its excess cash or free cash. Free cash flow is normally defined as cash flow from operations minus the amount of cash consumed to add plants and equipments. Such free cash if available can be used to reinvest in the business by acquiring more business, build more plants, or return to investors through dividend or repurchasing of common stocks. It also shows the amount of cash spent on acquiring businesses, disposal of assets and also acquiring of plants and equipment. If a company lent money to its executives to allow them to buy stock, it is also shown here.
  3. Cash flow from financing activities: This part shows how much money a company spends to repurchase its stock and also if the company is raising money by selling its stock or issuance or reduction of debt. A start-up business tends to have more financing activities than a mature business because it has little or no sales, so the cash has to come from somewhere to finance the business. Dividend payment is also indicated here. Remember the company can opt to utilize its free cash to return to investors by either repurchasing stock or paying dividend. Repurchasing of common stocks is usually a more cost-efficient method than in the form of dividend simply because dividend gets tax by Uncle Sam while stock repurchases do not. So the amount of tax saved can be used to repurchase more shares rather than to pay to Uncle Sam.
That's the cash flow statement in a nutshell. You can link the cash flow statement with the balance sheet by looking at the cash amount in the balance sheet and this amount comes from the final cash balance on the cash flow statement.

To sift for clues in the cash flow statement, it may be necessary to examine the cash flow side by side with the income statement, better still over multiple reporting periods. For example, if net earnings on the income statement have surged, but the actual cash received from operations is much lower, that could be a sign that bad debts or obsolete inventories are piling up and the future quarters' earnings could be lower.

A rough way to gauge if a company is playing the numbers game is to compare the rate of growth in net income with the rate growth in operating cash. If net income is growing at 10% but operating cash is growing at 1%, while in previous years, the two numbers grew at a fairly even rate, that could signal that net income isn't as solid as it appears. Or you can, alternatively, divide the net income with the total cash flow from operating activities. The close the ratio is to one, the higher the quality of the earnings.

As you can see, it is far more difficult to manipulate the cash flow statement than the income statement. But it still can be inflated. Again, Enron's cash flow statement is instructive. In its 2000 annual report, Enron showed that cash provided by operating activities came to $4.8 billion. But investors who looked thoroughly at the balance sheet and its footnote would notice that under its liabilities, it held $4.3 billion of customers deposits compared with almost nothing the year before, and hidden under footnote 3 on page 39, it states "At December 31, 2000, Enron held collateral of approximately $5.5 billion....shown as 'Customers' Deposits' on the balance sheet." Without this collateral, Enron's real operating cash flow would be negative $700 million. Furthermore, Enron also reported a onetime asset sales of $1.8 billion on its cash flow statement. With this, Enron's real operating cash flow fell deeper to negative $2.5 billion. Considering that Enron was showing total sales of $101 billion, a negative $2.5 billion cash flow is a sign that something is really fundamentally wrong.


Frank said...

Hi Brian, thanks for your good articles.
By the way, can you comment on my raw valuation of KO using Free Cash Flow?

I just take KO average Free Cash Flow for the past 3 years and discount it at 10%, with assumption that the FCF can grow at 6% thru eternity.

Example: KO Enterprise Value = FCF divided by 10% minus 6% (FCF/10%-6%) and i get KO rough valuation about USD55 per share (Enterprise value divided by number of share)

Buffett mentioned before somewhere in his shareholder meeting that he use 10% to discount.

And in his 1999 fortune's article, he mentioned that for long term, we should expect stock norminal return to be about 6% to 7%.

Can i expect Free Cash Flow to grow at 6% norminal rate, same as stock norminal return?

Just curious, what simple valuation method that you use to calculate rough intrinsic value?

Berkshire said...

Hi Frank,

I don't usually do an exact calculation on the IV. What I do is I just look at the FCF available, and how much multiples it sells for. For example, Sanofi Aventis, its FCF is about Euro.56 billion, but to be safer, say I discount it to Euro6 billion. Its share sells for about Euro46, and with an outstanding diluted no of share of about 1310 million shares, the whole company is selling for about E60 billion. So based on the E$6B FCF, the company is selling its FCF at a multiples of 10 times, which seems reasonable to me. But this way is not valuing based on IV which is the expected future value of all cash flow versus what the price is today. This way I just described is just based on the multiples on expected FCF of one particular year without application for future growth of the FCF and the applicable discount rate.

Of course, that is only the first step that arouse my interest if the stock seems to be priced attractively in that manner. If I am interested, I would further probe into the operations of the business, see what are the factors that can drive its revenue either lower or higher or what will sustain its revenue. Again in Sanofi case, big pharma depends much of its revenue on the drugs they sell, and most revenue are often driven from the top 3 to 4 drugs they sell, i.e., the top 3 to 4 drugs often account for 50% or more of the pharma company. Like Pfizer, its top drug, Lipitor, generates about $12B in annual sales, which constitutes for 25% of its annual revenue. But for all pharmas, its drug have a patent life span, and once the patent expires, it will be open to generics competition which means such drugs cannot command premium for its price. So understanding the company is more important after the price seems to be good.

For KO, I have a rough look before but it don't seems either cheap or costly. But in such times, I think there're better opportunities. If I were to value KO, with its FCF of about $5B (over the last 3 years), and with a growth rate of say 5%, to get to the IV, the following applies: step 1) $5b x growth rate = a, step 2) repeat step 1 for the number of years you think the company would exist but replace the $5B with "a" each time, step 3) discount "a" by the interest rate you'd otherwise get in a risk free investment back to today value, say treasury bonds, 4) add up all the the discounted value and you get IV.

Yes, Buffett did mention he expected 6 to 7% (somewhere that range) in 1999. Investors then were all expected much more in excess of that. Now it seems we should expect half of the 6 to 7%. After all, the would is deleveraging. With deleveraging, there's less growth because less money is in the system to generate money.

Just my two cents worth. I am always learning and the method I use often is changed for the better if I find what i use is not correct.

Frank said...

Hi Brian, thanks for your good idea, instead of using earning multiples, you smartly use FCF multiples.
By the way, can you give me a rough guide on bargain FCF multiple during recession (i.e how many times) we should look at?
And during good time, how many X of FCF multiple is consider expensive?
For understanding of business models, I use microeconomics ( Charlie mentioned that he grab a copy of microeconimics from Mankiw). According to Mankiw, only monopoly, duopoly and oligopoly can make economic profit in the long run because of the barier of entry they possess. Example will be Coke and Pepsi; Nestle, Kraft and Pepsi, Moodys and S&P, Gillette and Shick; AXP, Visa and Master etc.

Frank said...

Thank you for your reply and great bouncing ideas with you...

Berkshire said...

Hi Frank,

It is hard to scientifically put a number as to how expensive or cheap a multiple should be. Each industry and the company within that industry are different. As a rule of thumb, I think it may be best to compare to history and the average. Reasonable multiples would be anything below 15 but not necessary undervalue. Perhaps a multiple of 12 may indicate undervalue. Anything less than 12 or equal to that for a good company, especially with high possibility of recurring income like P&G, Coke, would indicate that the stock is selling for a discount.

I am unsure of the microeconomics that you mentioned about. Generally, the less competitors you have, the easier it is to make money. Monopoly exists in different situations, some monopolies exist because they are protected through gov intervention, some with product patent, etc. But all the time, as far as there's good money to be made, everyone wants a share of the economic pie. So the important thing is how good the product the company has is really immune from new product competition. Like Apple's product, theirs are more likely to be replaced by newer and more innovative products from competitors. Whereas, for KO, it is harder to replace it with a new coke. Look at the disaster that KO tried to replace its original coke with NEW COKE in 1988. Even when pepsi came up with its advertisement that proved pepsi tasted better than Coke, Pepsi still can't take away Coke's share.

As you can see, on the one hand, we humans, will replace technology products with yet better techno products. But for certain other products, like KO, no matter what other better products are on offer, we can hardly replace the older with a better products. I think this is a good case for further study so that if we can understand the underlying reason behind it, we can also understand why certain business is truly is better biz than others. I guess a big part of humans are because of the influence process. What influence us to stick to certain things - one thing is familiarity.

Penny Stock Blog said...

I have always thought that the income statement is the most difficult thing to understand. As far as a companies finances go.