The Curious Investor

The first thing any investor learns about is the importance of earnings to stock prices. The simple reasoning behind this is that a business is ultimately only worth what it can earn after paying down all its obligations. Earnings, however, can be distorted by all sorts of accounting maneuvers - one time events, interest, depreciation, etc.

So, how does one strip out all the crap? One method is to do just that. EBITDA, earnings before interest, taxes, depreciation and amortization, is a way you can analyze profitability in a manner that is free of non-operating expenses and non-cash charges. This a better method of core operating profitability. This allows one to be able to use EBITDA to compare companies across industries and measure their profitability trends against each other. How might you do this? The simple way is to create a few ratios. EBITDA to Sales would be a good measure of operating efficiency. Another might be Enterprise Value to EBITDA. Enterprise value is the theoretical amount that one would pay to take over a company - you would pay down the market cap and debt but then get to pocket all the cash. EV to EBITDA is a good valuation multiple as it assumes nothing. It gives the premium one would pay to take over a company assuming they intended only to run current operations with no further large capital investments.

Now, before you run off and start trying to value all companies based on EBITDA, realize that in real life you can’t just pocket your earnings without paying interest, taxes, depreciation, and amortization. As such, EBITDA is not meant as the be all and end all of valuation. If anything, it is more a tool to help you make comparisons from company to company so as to spot relative value. When looking at a particular stock, good EBITDA while a sign of profitability is not a sign of true earnings. So, what are true earnings if we can’t necessarily rely on the earnings reported on the income statement as net income or on EBITDA? True earnings are the dollar bills you actually deposit in your bank account - CASH! That’s what we’re all in business for right? To generate cash. The best way to measure this is to calculate free cash flow.

All the information you need to calculate free cash flow is available on the cash flow statement. Though this tends to be the most ignored financial statement, this might be the most important to any savvy investor as it allows one to get through all the BS and measure the company’s performance based on the actual dollars and cents it generates. Free cash flow is most simply calculated as operating cash flow - capital expenditures. We may return in the future to more complex methods of analyzing free cash flow particularly with regards to how one treats capital expenditures, but today we’ll pretend that it’s simply the reported values on the statement of cash flows. Basically, free cash flow is the actual cash the company earns over each quarter or year that it can put in its bank account and use for any purpose it likes - giving dividends to share holders, saving for a rainy day, or reinvesting for growth. Most of you probably thought that this was earnings but unfortunately, as a result of weird accounting rules earnings can sometimes be skewed away from this true value.

While in the long run earnings should eventually be somewhat similar to free cash flow, from quarter to quarter, this may not be the case and ultimately one of the most important aspects of performing such analysis on companies is not about the long run but about the short run and whether or not a company can pay the bills today. For example, if a company invests $1 million in a new plant this quarter, it may write down depreciations for the plant over 10 years. As a result, it may be able to still report positive earnings since it will only count $100,000 against itself this quarter, but since the $1 million is part of capital expenditures the true free cash flow for this quarter could be much less than earnings or maybe even negative. Negative free cash flow is never a good thing especially for a company that does not already have a lot of cash on hand as it could be a sign that the company will have some trouble paying bills and trouble paying bills leads to every shareholders worst nightmare, bankruptcies.

That being said, negative free cash flow or even low free cash flow is not necessarily a bad thing. Capital expenditures are important for any company to keep growing. If you do come across a company has very high capital expenditures, don’t immediately toss it out. Make sure to calculate Return on Invested Capital. This is defined as Net Income After Tax divided by (Total Assets minus Excess Cash minus Non-Interest Bearing Current Liabilities) again all things that can be found on the three sheets. ROIC is also often calculated for you on financial websites whenever you look at a stock. High ROIC relative to the current cost of capital, which you can assume is a within a few percentage points of the ten year treasury yield, is a sign that a company should continue to spend on capital expenditures and should assuage any fears that you might have about a company sacrificing current free cash flow through its spending.

So, in sum, earnings aren’t the be all and end all of a stock’s value though they tend to be the most hyped. When you’re looking to analyze a stock and trying to find something that maybe other people have missed in its financial statements, take a look at other measures of profitability - EBITDA and Free Cash Flow. These, often times, will provide you even more insight on the true health of a company’s operations.

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