Looking past accounting tomfoolery
We hear it all the time, “Businesses are worth the net present value of future cash flows.” Usually a statement like this is followed by someone whipping out some convoluted discounted cash flow model. These models are usually based on free cash flow which is nearly always significantly different from the earnings or net income number reported by publicly reported companies.
Income statements mislead investors
Income statements are build off of generally accepted accounting principles (GAAP). Chief among these principles includes:
- Recognizing revenue only when it is realized and earned as opposed to when cash is received (accrual basis versus cash basis)
- Matching of expenses to the recognition of revenue as opposed to work is actually done or when inventory is purchased
These principles are designed to allow greater evaluation of a company’s profitability because it actually matches how much must be spent to earn a given level of revenues. Unfortunately, this does not always give the best representation of a company’s performance. A particular drawback to accrual accounting is the fact that expenses not matched to revenue are typically accounted to on a period-by-period basis. Most operating costs fall into this category. As a result, income statements and GAAP earnings can be particularly misleading for growing companies which may be spending more higher administrative and office costs in preparation for scaling the business, but for which accrual accounting of revenues delays the impact of sales gains.
A great example of how this can mislead investors was the hoopla that surrounded Apple’s most recent earnings report. As a result of an accounting decision to capitalize iPhone revenues over the two-year contract that users sign, iPhone sales revenues are actually only reported at 1/8th the level that they are actually coming in. For a more detailed analysis, check out Bullish Cross.
Why free cash flow as opposed to cash generated?
The use of free cash flow comes down to an argument over enterprise value versus equity value. The focus on net income, earnings, and adjusted earnings (as Andy Zaky uses in the aforementioned Bullish Cross link) by investors is an example of determining market value. This is the value investors are generally willing to pay for equity ownership in the business. Earnings, because they include interest expense and tax expense and other expenses that come with running a business, (even if not perfect on a period-by-period basis) approximate potential distributions to shareholders in the long term.
Free cash flows, on the other hand, are capital structure neutral. They measure how much cash the company’s operations generate and minus the minimum capital that you need to employ (maintenance capital expenditures) to maintain this level cash flow. Discounted cash flows based on FCF allow you to target enterprise value. Enterprise value is the “true” value of the business in its entirety. It’s how much you would want to pay to acquire equity ownership as well as buyout any debt held by the firm (or how much more debt you could justify adding to the firm’s capital structure).
Value and profitability are not necessarily equivalent
What about taxes, interest expenses, and other expenses that seem to be excluded even if they are necessary? What about investments in R&D or expansion capital expenditures? This is the great dilemma of modern financial valuation. Theoretically, financing expenses and non-operational taxes and a whole host of other activities with consume cash are at the discretion of ownership and management. As a result, the value of a business can be changed dramatically by new ownership and, thus even if a company is not profitable due to large non-operational expenses, it can be very “valuable” based on free cash flow performance. And, this is where financial analysis can often unlock “hidden” value in a business.
Full disclosure: Author is long shares of AAPL at the time of writing.
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