This is the first in a series of tips, taken from our new course How to Pick Winning Stocks. I will follow up with more in coming weeks. 

If a company is worth the sum of its future cash flows, then it’s obviously helpful to have an idea of what it is producing today as a sustainable level of cash generation – of course, this may grow in future, but using a sustainable free cash flow measure gives you a more powerful valuation multiple than using the P/E, without the need to do a full- blown DCF.

I am a bit geeky so you would expect me to make a lot of modifications to the reported numbers, for things like tax settlements, pension top-ups and other non-recurring items. You don’t need to go to this level of detail – if you make two simple adjustments (well they are simple in theory but not always in practice), you will produce a reasonable number.

1                     take out growth capex
2                     adjust for stock-based compensation

There are other adjustments you can make, but these are two of the most important, especially for modern tech stocks. The theory is quite simple:

1                     to the extent that a company is investing or future growth, incremental capex to build a new facility is a cash spend over and above what is required to achieve a steady state of revenue. Some companies will explain what their growth and maintenance capex is, the latter being the figure which is required for a steady state valuation.
2                     Stock-based compensation is generally added back to “adjusted” earnings, but it’s often a large item and it’s not as if this is cost-free to shareholders – there is a dilutive impact. This cost needs to be reflected in the sustainable cash flow calculation.

As I mentioned, the practical implementation is more difficult, but there are a couple of simple tricks that you can do to get a rough feel of the approximate level of sustainable cash flow. And these are short-cuts, only rough and ready indicators. In practice I would generally do a lot more work, but sometimes I will use these to give an initial view, for example when initially deciding if an idea is worth pursuing.

1                     use the depreciation and amortisation number if there is not a better way of determining growth capex. It sounds slightly counter-intuitive, using a depreciation figure to derive a cash flow estimate, but I have found that it can often be a reasonable substitute. The amortisation is only that which related to capitalised intangibles – software and R&D usually.
2                     For the stock based compensation, this is much harder, and if this method gives an unusual result, I may take the average over several years or refine the calculation further – this is a complicated subject and worthy of a blog on its own. Again this may raise some eyebrows but I look at options granted last year times the average share price – this gives me an approximation of the equivalent cash cost of buying back the stock to offset the dilution. It’s not perfect but it’s better than ignoring the cost, in my view.

HINT: If you do want to calculate sustainable free cash flow, you need to have a sensible capex number. Don’t make the mistake this hapless Alphabet analyst did:

This analyst has forgotten capex entirely! Sentieo puts this number at $25bn in 2018 and $24bn in 2019 (and depreciation and amortisation at $9bn and $12bn, respectively). This makes quite a difference to the valuation. I actually feel slightly sorry for the analyst and I am not sure which firm is responsible – I picked this up from Twitter and forgot to note the name of the person (please let me know so that I can credit you!).
I use this quick estimate of sustainable free cash flow to give an indication of the steady state FCF yield, which is one of my initial checks as whether an idea is worth investigating further.

This is the first in a series of tips, taken from our new course How to Pick Winning Stocks.  The course is discounted by 20% until 10/10 as a special launch offer. More tips in my forthcoming book, available on Amazon - links for US and  UK.

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