Free cash flow

Non-cash transactions: Filling a free cash flow gap

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The IASB is developing proposals to improve disclosure of non-cash investing and financing transactions. A single tabular note would show these transactions alongside the equivalent cash flows reported in the cash flow statement.

We support the proposals. Non-cash transactions are, in effect, pairs of offsetting cash flows, and omitting them can materially distort free cash flow. The proposed disclosure would give investors the data needed to make adjustments we have long advocated, although the need for careful analysis, and potentially further adjustment, remains.

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Stock-based compensation: The cash flow question

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How equity-settled stock-based compensation should be reflected in free cash flow analysis remains the subject of ongoing debate. There are two distinct questions: whether an effective cash cost exists when no shares are repurchased to offset dilution, and whether that cost should be measured at grant date or vesting date.

Both questions have direct implications for free cash flow, DCF valuation and comparisons between companies with different repurchase policies. We have previously argued that an effective operating cash outflow should be recognised at grant date. In this article we address the arguments raised against that view.

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Debt-like customer advances and DCF valuation

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Oracle Corporation says it will use customer advance payments to enhance cash flow and mitigate the amount of debt required to finance its AI infrastructure investment. We think investors should consider whether this, and other components of net working capital, are in-substance debt financing and adjust their analysis accordingly.

The standard approach of treating working capital as operating assets and liabilities for DCF valuation may not always be the best. In an interactive model, we demonstrate how receivables and payables (and similar working capital items) can be treated as financing items in an enterprise free cash flow DCF valuation.

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AI Hyperscalers – Capital expenditure and free cash flow

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The rapid expansion of AI related infrastructure by the big-tech hyperscalers, and the effect this capital expenditure has on free cash flow, has been a recent focus for equity markets. But does the capital expenditure reported in financial statements provide a complete picture?

We explain how metrics commonly used by investors understate capital expenditure and overstate free cash flow. Only by ensuring that the effects of leasing and other ‘effective’ flows are fully reflected in free cash flow will this important measure be relevant for equity valuation.

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DCF valuation: Operating versus financing flows

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One of the most important principles of enterprise free cash flow DCF valuations is to separate operating and financing flows. A forecast financing flow, such as the planned issue of new equity, affects the allocation of value between claimholders and not (usually) the value of the enterprise itself.

We provide an interactive model to illustrate how anticipated new equity finance should be included in DCF, and the related concept of pre-money and post-money equity values. We also examine some more complex situations where the separation of operating and financing effects can be challenging, and where financing flows do affect value.

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DCF models: Valuation date and cash flow timing

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One of the errors we often encounter when reviewing DCF models concerns valuation date and cashflow timing adjustments. Although the effect may not always be that material, getting these adjustments wrong undermines the credibility of DCF valuations.

We explain the correct application of valuation date adjustments, the necessary amounts for the enterprise to equity bridge, and how to roll-forward values to derive 12-month price targets. We also provide a downloadable model to illustrate these different elements of DCF.

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Valuing sustainability risks and net-zero commitments

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Investors are paying increased attention to risks and opportunities arising from sustainability related issues, particularly the effects of climate change and related ‘net-zero’ commitments made by many companies. Some sustainability risks directly affect financial statements, but you need to look further when considering inputs for equity valuation.

Risk affects different aspects of equity valuation. It is well known that risk factors affect the discount rate, but the impact on other valuation inputs may get less attention. We explain how sustainability risks and opportunities should be included in your analysis.

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Cash is king – except when analysing performance

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We often see investors using cash flow metrics, particularly cash from operations, as a measure of performance. Cash flow may even be preferred to profit because it is supposedly more reliable and less subject to management judgement and potential manipulation … “cash is a fact, but profit is an opinion”.

We explain why cash flow may not provide the insights into performance that some investors expect, and how cash flow can often be managed even more freely than profit. Cash flow is nevertheless an important component of equity analysis and ‘following the cash’ is vital to understanding a business.

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Why IFRS 18 is good news for investors

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The IASB has issued its new international standard for the presentation of financial statements – IFRS 18. Changes that will benefit investors include a prescribed operating-investing-financing structure for the income statement, new defined subtotals, additional disaggregation, and a more relevant cash flow presentation.

IFRS 18 will better align financial reporting with equity analysis and provide additional and more comparable data to facilitate that analysis, including data that should help investors to forecast performance and assess risk.

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DCF Valuation: Financial leverage and the debt tax shield

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DCF valuation models can either be based on free cash flow attributable to equity investors or the free cash flow available for all providers of finance. Each requires a different approach to allowing for financial leverage, including adjustments to beta and recognition of the debt interest tax shield.   

We present an interactive DCF model that illustrates discounted equity cash flow and discounted enterprise cash flow using both the WACC and APV methods. Understanding each approach helps in ensuring consistent valuations, whichever method you choose to adopt.

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New supplier finance disclosures will affect operating cash flow

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Reported operating cash flow, leverage and net working capital measures, may be misleading if a company engages in supply chain financing. The impact can be significant but, at present, calculating the effect and making adjustments is difficult. Additional IFRS disclosures proposed by the IASB will help.

We explain the new disclosures and provide an interactive model to illustrate how to use them to calculate more realistic measures of cash flow, leverage and working capital. The adjustments depend on whether liabilities are classified as trade payables or debt finance and may require the inclusion of a non-cash ‘effective’ operating cash outflow.

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DCF terminal values: Returns, growth and intangibles

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If DCF terminal values are based on continuing forecast cash flow, it is important that the reinvestment assumption is consistent with long-term return expectations. We provide an interactive DCF model that demonstrates four alternative cash flow growth-based terminal value calculations, along with related returns analysis.

One of the challenges when using returns in equity valuation is the limited recognition of intangible assets. Adjustments to capitalise intangible investment do not change cash flow but can help in ensuring that the assumptions that drive forecast cash flows are realistic.

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DCF and pensions: Enterprise or equity cash flow?

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Defined benefit pension schemes create two leverage effects – financial leverage due to the debt-like nature of pension deficits, and asset allocation leverage if pension assets are not matched with pension liabilities. In DCF valuation these effects must be correctly, and consistently, included in both the discount rate and free cash flow.

We use an interactive model to demonstrate four possible DCF approaches based on enterprise and equity cash flows. Our preferred approach uses enterprise free cash flow with the effects of asset allocation leverage excluded from the discount rate.

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Amazon free cash flow – an update

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Last year we published an article about the calculation of free cash flow and the alternative approaches used by Amazon. That original article is still very relevant; recent accounting changes have prompted us to publish an update.

New accounting rules effective in 2019 change and improve the data available to you when making the adjustments we advocate. We explain these changes, provide updated free cash flow measures for Amazon based upon their 2019 financial statements, and consider the relevance of maintenance and growth capex in the analysis of free cash flow.

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Leasing and leverage – credit rating agencies disagree

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Rating agency Fitch recently announced its approach to dealing with the new lease accounting in its credit metrics. Their approach is at odds with that already published by Moody’s and Standard & Poor’s. Of particular interest is the way the rating agencies deal with the differences between IFRS and US GAAP.

We explain the different approaches of the rating agencies, how we think investors should calculate key metrics, such as leverage and cash flow, and the importance of considering the impact of leasing on operating leverage and business flexibility.

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Why you should ‘forward price’ valuation multiples

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The number of alternative valuation multiples can seem endless. Many different metrics, such as EBITDA and EPS, can be combined with different measures of value, such as the stock price and enterprise value. But there is a further variation that often seems to be overlooked – the pricing basis.

Valuation multiples can be based on a historical price (or EV), a current price, or the less commonly used forward price. We advocate greater use of forward priced multiples. They are more comparable and relevant for relative valuation comparisons and provide a better basis for terminal values in DCF analysis.

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Leverage and cash flow effects of supply chain finance

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Supply chain finance, such as factoring and reverse factoring, are often labelled as tools used by companies in financial distress. Although we believe they are valid financing techniques, the reporting of these arrangements can affect leverage and cash flow. Due to poor disclosure you may not even know about it. 

Debt finance may not appear as debt in the balance sheet.  Operating cash flows may not include payments for some operating expenses or may be distorted by changes in financing being classified as operating. We explain how supply chain finance works and how you may need to adjust key metrics.

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Linking value drivers and enterprise value multiples

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Target valuation multiples that are implied by key value drivers are a great way to better understand equity valuation and how the characteristics of a company affect value. The approach incorporates the same links with underlying value drivers on which DCF is based, but in a simplified way that is more intuitive than a full DCF model.

Our target multiple model can be used to estimate a deserved valuation multiple for a company, sector or index, to reverse engineer returns or growth implied by a current market valuation multiple and to derive a terminal value multiple in DCF analysis.

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In search of free cash flow – Amazon

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Amazon provides investors with three alternative calculations of a free cash flow metric. For 2018 these range from $8.4bn to $19.4bn. In contrast our preferred approach gives a negative free cash flow of $3.4bn. What explains these material differences?

The disclosures by Amazon about its free cash flow measures are good and the calculations go further than many other companies. However, in our view important components are missing. We explain our additional adjustments in respect of leased assets and stock-based compensation.

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When cash flows should include ‘non-cash flows’

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The problem with cash flow statements is that they only include cash flows. This may seem odd, given that the purpose of cash flow statements is simply to report cash movements. However, most cash flow analysis is focused on sub-totals and it is here that offsetting flows arising from non-cash transactions become important.

We explain why we believe adjustments to cash flow sub-totals are required and for which transactions you should adjust.

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