Five year summary of PDCO stock price. From 2012 to 2018

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Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.

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Revenue is vanity. Profit is sanity. And cash is reality.

Free Cash Flow Is Superior to EBITDA

July 28, 2018

It took over ten years for people to get used to the idea of an automatic elevator; over 30 years to feel okay about eating shrimp (they were considered the ocean’s cockroach); and 20 years passed before passive investing, tracking the movement of an index such as S&P 500, was accepted (in the ‘90s it was still considered to be un-American.)

This essay reflects whether it is time that we change how we look at the operating performance of a business.

What's wrong with EBITDA, net earnings and book value

Earnings before interest, tax, depreciation and amortization (EBITDA) allows management to boast on theoretical, imaginative financial results. It is similar to a marathon runner explaining that he or she finished a marathon in less than four hours, if only they had not taken a 25-minute rest in the second hour. 

EBITDA figures are always higher than free cash flow numbers and result in a higher valuation for the company and a greater ability to take on debt. It should be of little surprise that it was popular in the ‘80s - the era of leveraged buyouts.

Net earnings are suspicious too. Because management is acutely aware that Mr Market watches net earnings like a hawk, management arnings. In addition, net earnings are subjective as expenses, such as depreciation, goodwill amortization and leverage are highly dependent on management decisions. As a result, it is awfully hard to compare the net earnings of one company to theother. 

While net earnings are influenced by management’ decisions, reported book value measurement is dependent on the accounting convention of the time. And while intentions may be innocent (for both the accountants and for management), the reported book value often results in nonsensical numbers for the investor.

Consider goodwill as an example. This asset category represents the excess purchase price above the net fair value of the company acquired. While it is considered an asset, the chances the reported value will be realized is as real as the chances that another purchaser will price the goodwill account as reported on the balance sheet. That rarely happens.

A much better alternative

Free cash flow provides a better picture of how a business is doing. Free cash flow aims to answer one question: how much cash is left to the owner of the business after all required expenses and taxes have been paid.

The classic definition of free cash flow is cash flow from operations less capital expenditures. I like to use a slightly more detailed approach, which I will describe in the case study below.

With free cash flow, it is easier to compare the profitability of a real estate firm to a company that sells dairy products. Both companies collect and spend cash and both companies require cash to maintain their operations. A real estate company will repaint the buildings it owns and a dairy products company will upgrade the manufacturing plant. For the investor, in both scenarios, there is really one issue: how much cash will be left at the end of the day.

If we can estimate how much cash flow a business will generate in the future, we can decide whether the current price of the stock fairly represents the expected future cash flow. While this is a simple, fundamental concept to stock investing, it is also one of the hardest ones.

It is hard because the future is unknown, and because the future economics of a company are dependent on many immeasurable variables.

Consider the case study below where I describe a company that sells dairy products. Its profitability is dependent on a consumer's preference; on the cost of raw milk; on changes in the competitive landscape; and on its distribution system and manufacturing capabilities.

A case study

Observing free cash flow was the reason why I bought the stock of Lifeway Foods (LWAY) a few weeks ago. Between 2017 and 2008 the company earned a total of $32 million. But the reported earnings included $22 million of depreciation expenses. So I added those back. I also removed capital expenditures and and the working capital expenses (such as purchasing inventory). These variables were $38 million in total (these expenses are not reported in the income statement.) The result was that Lifeway earned a total of $17 million in free cash flow over the past decade.

I estimated that over the next ten years the company's free cash flow will be $17 million also. And so we can say that on average the company's free cash flow each year will be $1.7 million.

(For simplicity sake, I assume no change in shares outstanding and used the current number of 16 million shares in my calculations.)

At the purchase price of $4 per share, I received $2 of tangible book value and an expected ten cents per share of free cash flow over the next decade. Grab your HP12C, and you will find this is an expected, reasonable yield of 10%.