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The company reports £63m of accounting earnings. However, its free cash flow, after adding back the non-cash charge of depreciation, working capital changes, and cash payments for interest, tax and fixed assets, could be said to be just £28m.
It's obvious that MMT's cash flow suffered during 1999 as a low cash tax payment during 1998 caught up with the company the following year. So for those using a cash flow measure, is it realistic to judge MMT on cash tax basis when payments or refunds from previous years can be included?
A free cash flow valuation, subtracting the working capital change from post-tax profits, would lop 40% off MMT's capitalisation. That seems unjust, simply on the basis that the company is paid two months after sending out its invoices. Maybe some sort of small valuation adjustment could be made for working capital outflows. But why bother, when the customers will clear their debts in a few weeks' time?
Summary
The argument for concentrating on a company's cash flow is simple -- "profits" are determined with a heavy dose of an accountant's subjectivity. For the unscrupulous manager, a "change of opinion" can lead to earnings per share manipulation. Not all earnings are equal, so to speak.
Cash flow, on the other hand, just can't be fudged. Cash is either in the bank or it's not. And by how much a company's bank balance has changed is shown within the cash flow statement.
So, given the lack of judgement needed to assess the company's cash flow statement, surely it makes sense for shareholders to concentrate on this particular part of the accounts for valuation purposes?
Well, no.
Free cash flow
The alternative to earnings is free cash flow. Free cash flow is the measure by which a company generates cash over and above what's required to sustain its current competitive position. Free cash flow then funds such discretionary corporate activities as the payment of dividends, expansionary capital expenditure and acquisitions.
This is a simplified example of how a profit and loss account and a cash flow statement can compare within a set of accounts.
Profit and Loss (£m)
Operating Profit 100
Interest paid (8)
Tax (29)
Earnings 63
Cash Flow (£m)
Operating Profit 100
Depreciation 20
Change in working capital (25)
Other (5)
Operating Cash flow 90
Operating Cash flow 90
Interest paid (7)
Tax paid (30)
Capital expenditure (25)
Acquisitions (2)
Dividends paid (10)
Financing 5
Increase in cash 21
So, is it fair to assume that the "accounting" valuation of the company is twice that of a similar cash-based valuation?
No.
There are three points to consider when conducting free cash flow valuations.
Interest and Tax
Let's take Qualiport member MMT Computing (LSE: MMT) and their recent tax charges and payments.
Year to 31st August
1999 1998
(£k) (£k)
Profit before tax 9,711 10,005
Tax (2,948) (3,337)
Profit after tax 6,763 6,669
Cash tax payment (4,266) (1,927)
To me, it makes sense to focus on the "smoothed" tax charge from the profit and loss account, rather than to use the seemingly haphazard cash payments to judge a company's valuation.
The same, but to a lesser extent, goes for interest paid and receivable. What's owed and what's paid to the lender will usually differ in any given year. Having the luxury of paying interest in arrears, effectively boosting cash flow by temporarily holding the lender's instalment, shouldn't be confused with generating any extra "profit".
Working Capital
Some businesses take cash up front and only then provide the goods. Should these companies have greater valuations than those companies that have less favourable working capital profiles? Perhaps, but not to the extent that free cash flow measures indicate.
Back to MMT. Compare post-tax profits to the increase in cash tied up in working capital.
Year to 31st August
1999 1998
(£k) (£k)
Profit after tax 6,763 6,669
Working capital change (2,783) (3,255)
Then there's also the question of "expansionary" working capital. How much of that working capital outflow was necessary for the company to sustain its current competitive position? How much of it was discretionary (used for the expansion of the business) and therefore should actually be included within any free cash flow figure?
Investigating the working capital record of the company and its clientele is a must for investors. For MMT, the company has consistently operated with a working capital outflow for many years and its debtors are "safe" blue chips.
The danger signs to look for are huge and growing outflows of working capital, especially when the company fails to generate any cash at all from operating profits. If the working capital movements cast doubt over trading, then no method of valuation would make the company a tempting investment.
Depreciation and capital expenditure
Depreciation represents the net cost of purchasing an asset. It's a non-cash charge that is evenly spread over the asset's expected life and reflects "wear and tear". The charge also effectively represents a proportion of the asset replacement cost.
Depreciation is calculated on the historical cost of an asset. Therefore, taking the "asset replacement" view, subsequent inflation may cause the depreciation charge to undershoot the capital expenditure required to sustain the company in its current competitive position. If this is the case, then earnings just taking into account depreciation may be overstating "true to life" profits.
There are all sorts of calculations that can be performed to try and adjust depreciation to reflect "maintenance" capital expenditure. That's beyond the scope of this article, but suffice to say, some sort of adjustment should be considered.
Of course, it pays to be invested in companies that have low fixed asset requirements in the first place. These operations tend to have the greatest return on equity, the key indicator for shareholder profitability.
If you're involved in asset-light companies like MMT, then few depreciation adjustments have to be performed. The difference between depreciation and actual cash capital expenditure, when compared to overall profits, is neglible.
Year to 31st August
1999 1998
(£k) (£k)
Profit after tax 6,763 6,669
Depreciation charge 627 625
Capital expenditure 563 749
Although I study cash flow statements, I rarely use them for valuation purposes. In my view, cash-based valuations lead investors astray.
I pay little attention to cash taxes and cash interest payments, except only to check for large ongoing discrepancies with what's reported in the profit and loss account.
I also ensure that working capital changes are not bleeding the company dry of cash. I try to establish whether the company has maintained a consistent and reasonable cash operating record. If it has, then I have little concern over trying to adjust earnings to cater for working capital movements. Also, focusing on companies with little need for capital expenditure removes any thoughts about understated depreciation charges.
In short, picking the correct type of business removes the need to use cash-based valuation methods. Either the reported earnings are realistic, or they are not. And so the cash flow statement should only validate earnings, and not act as a replacement in any valuation technique.
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