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FCF and WC

Analysing companies' finances and value from their financial statements using ratios and formulae
Supermuppet
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FCF and WC

#348118

Postby Supermuppet » October 15th, 2020, 10:54 pm

Hi All,

FCF/MV or FCF/EV are great value metrics, since using free cash flow instead of reported profits can be a good way to avoid overstated profits that are not backed up by real cashflows.

However, working capital movements can be very lumpy and potentially over/understate the true level of "sustainable" or normalised free cashflow. Take a look at the cashflow statement in PZ Cussons latest annual report and you'll see what I mean.

Does anyone have any expert knowledge of whether FCF ex Net Change in WC is therefore a sensible alternative approach? Its not the same as EBITDA since there are still various non-cash charges/gains/write offs that pass through the p&l that FCF removes, separate to WC (inventory, receivables, payables, paid expenses).

Thanks
Steve

dealtn
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Re: FCF and WC

#348208

Postby dealtn » October 16th, 2020, 10:58 am

Supermuppet wrote:Hi All,

FCF/MV or FCF/EV are great value metrics, since using free cash flow instead of reported profits can be a good way to avoid overstated profits that are not backed up by real cashflows.

However, working capital movements can be very lumpy and potentially over/understate the true level of "sustainable" or normalised free cashflow. Take a look at the cashflow statement in PZ Cussons latest annual report and you'll see what I mean.

Does anyone have any expert knowledge of whether FCF ex Net Change in WC is therefore a sensible alternative approach? Its not the same as EBITDA since there are still various non-cash charges/gains/write offs that pass through the p&l that FCF removes, separate to WC (inventory, receivables, payables, paid expenses).

Thanks
Steve


I don't exclude working capital, but want to understand it. It will depend to some extent on the age of the company and its growth, and what business it is in.

I might consider how the movement averages over time, and is it susceptible to large orders that could be lumpy. Also has there been a change in payment policy.

Young and growing companies will have growing input costs occurring before the time lagged selling and money owed etc. The faster this growth the greater the effect of that time lag.

I would also be looking at the creditors book, are there potential bad debts etc.

Similar issues are on the capital expenditure line. Is expenditure "maintenance" to stand still (offsetting likely depreciation), or is it capital expending to grow and reap the reward in the future?

So these qualitative measures are good tools, but need quantitative adjustments.

Supermuppet
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Re: FCF and WC

#348389

Postby Supermuppet » October 16th, 2020, 9:43 pm

Hi Dealtn

Thanks for your comments - averaging FCF or the WC part over previous years is an option to smooth lumpiness, but it moves the goal posts and complicates things somewhat by adding info from past years to the mix, and it penalises growth companies by diluting higher current year with lower past years whilst flattering companies in secular decline by including higher past years (I know it could be helpful for cyclical companies). So it throws more time dependency issues into the problem.

What do we do if we limit the analysis to the latest accounts?

The problem with qualitative adjustments is that it's not something that that can be down systematically which is what im searching for: an improved definition of OCF/FCF if possible.

The problem with maintenance Vs growth capex is that companies never split this out anyway so impossible to say - unless you subtract depreciation and say anything in excess of this is growth capex.

Thanks
Steve

Arborbridge
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Re: FCF and WC

#348418

Postby Arborbridge » October 17th, 2020, 8:37 am

FCF to equity, always seems a reliable factor to look at, but I'm not sure how much notice to take of it. I've known companies with very poor cash flow and wondered whether the dividend is sustainable: but within a couple of years, the situation can reverse and be positive ...... or deteriorate.

There was an interesting thread in which the free cash flow of United Utilites came up (well, I brought it up) and amongst the contributors was Gengulphus, whom I've always admired as a very knowledgeable and analytical sort of person. He wrote:
"The result is that personally, I've given up even trying to calculate free cash flow myself, and I treat free cash flow figures from free third-party sources with considerable scepticism because I suspect they use over-simplistic calculation methods very uncritically to keep costs down. IMHO keeping an eye of a company's net debt (or occasionally net cash) probably does about as good a job of keeping track of its cash situation, and although one needs to watch out for companies 'hiding' debt, I prefer that to the uncertainty about the maintenance-vs-new capex breakdown issue that affects almost every company. "

Link here: viewtopic.php?f=15&t=25337 You need to scroll down to find the discussion.

Hope this might throw some alternative views on the problem!

Arb.

dealtn
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Re: FCF and WC

#348447

Postby dealtn » October 17th, 2020, 10:57 am

Supermuppet wrote:Hi Dealtn

Thanks for your comments - averaging FCF or the WC part over previous years is an option to smooth lumpiness, but it moves the goal posts and complicates things somewhat by adding info from past years to the mix, and it penalises growth companies by diluting higher current year with lower past years whilst flattering companies in secular decline by including higher past years (I know it could be helpful for cyclical companies). So it throws more time dependency issues into the problem.

What do we do if we limit the analysis to the latest accounts?

The problem with qualitative adjustments is that it's not something that that can be down systematically which is what im searching for: an improved definition of OCF/FCF if possible.

The problem with maintenance Vs growth capex is that companies never split this out anyway so impossible to say - unless you subtract depreciation and say anything in excess of this is growth capex.

Thanks
Steve


I agree and came to the same conclusion you are making (I think?) that it is difficult, if not impossible, for analysis to be completely systematic.

I use FCF, and others in combination, such as ROE, as an initial filter. That (vastly) reduces the number of companies I then have to dig deeper into. I am happy with this, and have the time (and inclination) to do so. I have never found the "free lunch" system that short-cuts this for me. The best alternative to doing it myself is freeing up that time, and paying someone else to do it for me. Terry Smith, Nick Train etc.

TheMotorcycleBoy
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Re: FCF and WC

#348948

Postby TheMotorcycleBoy » October 19th, 2020, 1:42 pm

Supermuppet wrote:Hi Dealtn

Thanks for your comments - averaging FCF or the WC part over previous years is an option to smooth lumpiness, but it moves the goal posts and complicates things somewhat by adding info from past years to the mix, and it penalises growth companies by diluting higher current year with lower past years whilst flattering companies in secular decline by including higher past years (I know it could be helpful for cyclical companies). So it throws more time dependency issues into the problem.

What do we do if we limit the analysis to the latest accounts?

The problem with qualitative adjustments is that it's not something that that can be down systematically which is what im searching for: an improved definition of OCF/FCF if possible.

The problem with maintenance Vs growth capex is that companies never split this out anyway so impossible to say - unless you subtract depreciation and say anything in excess of this is growth capex.

Thanks
Steve

You may find this https://www.amazon.co.uk/Value-Investin ... 0471463396 of interest. In the book's sections on "Earnings Power Value", IIRC the author mentions "growth" and "maintenance" capex. Forgive me, I forget the conclusion of it all, but I note that used copies of the book are coming in at about £5, and my recollection is of a useful and informative read; so it might be worth a punt.

Matt


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