Free Cash Flow, Tax And Capital Expenditures

I wanted to add some additional points on FCF (free cash flow) which I brought up in analyzing the Statement of Cash Flows before moving onto the future posts on balance and income statements.

Tax Adjustments

If a company receives a tax deduction when employees exercise their stock options, does this count as cash from operating activities? Or if the company defers its income taxes to a later period, does this count as cash from operations? I don’t think so.

The FCF is supposed to be derived from the operations of the business. In the updated version of the intrinsic value spreadsheet, the FCF number now subtracts deferred taxes and “others”. I mentioned this in the DCF post. Thanks to Jim for making me think about this.

Capital Expenditure Adjustments

I would say the most difficult aspect of trying to calculate FCF is determining the amount of capital expenditure used to maintain operations and market position versus the amount used for growth. A simple example would be to think of a retailer like Wal-Mart (WMT).

In 2008, Wal-Mart spent $14.9 billion on capital expenditure. Of that $14.9 billion, 100% of it did not go to opening new stores or expanding to new emerging markets. A certain percentage was used to maintain its current stores. The shelves have to be filled, maybe the plumbing needed to be fixed or the walls had to be repainted.

The point is to find (or estimate) how much of the company’s cap ex is for maintenance which should then be subtracted from Cash From Operations, whereas the cap ex used for growth should not be subtracted. Calculating these numbers is much easier said than done. You can read a very good explanation from Joe Ponzio of F Wall Street where he previously wrote how to find the maintenance capex for Wal-Mart.

If you don’t feel inclined to go through so much data (like myself), simply subtracting the given cap ex is an accepted and conservative practice. The reason people go to such lengths to find maintenance cap ex is to find value a majority of investors cannot see.

Understanding the Industry and Company

Positive FCF for every company is not possible. That doesn’t mean a company with negative FCF is bad. In some industries, companies might choose a strategy of declining or negative FCF in the short term for a great increase in future shareholder value.

One example is the oil industry and within that industry, take a look at Transocean (RIG). A cyclical industry and high cap ex business, yet it’s able to throw off huge amounts of FCF. Transocean and most oil drilling companies forego FCF in the short term to create immense shareholder value in the future.

Conclusion

Cash is a fact but there are lots of items which can be left out or moved to another section of the statements.

Stick with the cash that comes from operations rather than one time occurrences.

Going the full length to find the real maintenance cap ex will give you more investment opportunities.

It’s always a good idea to understand the business’s cash strategy.

Disclosure: No positions in any stocks at time of writing.

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