QUALIPORT
Free Cash Flow Is King

By Maynard Paton (TMFMayn)
January 21, 2002

Carburton Street, London -- Earnings are opinion; cash is fact. When running a business, it's cash profits that business owners want. More to the point, it's 'free' cash they require.

Free cash flow is the measure of cash a company generates over and above what's required to sustain its current competitive position. It funds such discretionary corporate activities as the payment of dividends and acquisitions. Furthermore, it's a very useful tool when assessing a company's intrinsic value.

There are many different formulas around that calculate a company's free cash flow. And like just about everything else to do with investing, the process is far from an exact science.

My definition

That said, free cash flow is typically defined as: Operating profit + depreciation +/- change in working capital - cash interest payments - cash taxes - maintenance capital expenditure.

But as I outlined in this article, I personally use this simplified calculation: Profit before tax + depreciation - total capital expenditure - tax.

Why the focus on depreciation and capital expenditure ('capex')? To recap, depreciation is calculated on a historical cost basis. It reflects the declining value of an asset due to wear and tear. If the company is to remain competitive, worn and torn assets eventually have to be replaced.

Because of inflation, the cost of the replacement asset is almost always higher than the original. But with accounting profits calculated using the depreciation charge, the greater the reliance a company has on fixed assets, the more likely the company's earnings will overstate its underlying cash flow.

Lumpy or smooth?

When outlining my free cash flow formula, I wrote: "To keep things simple, and to punish asset-heavy companies, I tend to take all capital expenditure as [ongoing] maintenance spend"

But unfortunately, companies do not tend to have 'smooth' capex programmes. Instead, companies can have a few lean capex years, followed by a year or two of heavy spending. Taking one year's figures to calculate a company's free cash flow can therefore be misleading.

Take Qualiport firm Johnston Press (LSE: JPR). Here's the company's 2000 free cash flow calculation.

Year to December 2000         (£000)

Pre-tax profit                66,545
Depreciation                  11,534
Capital expenditure          (19,892)
                              58,187

Tax (@ 29.5%)                (17,165)
Free cash flow                41,022

But here's how Johnston's capex compares with its depreciation charge over recent years:

                             1996    1997    1998    1999     2000                           

Depreciation (£000)         5,478   6,531   6,793   9,224   11,534
Capital expenditure (£000)  5,516   9,912   7,924   9,026   19,892

Relationship

In this situation, assessing Johnston's accounts over, say, five years, could gauge a more accurate relationship between depreciation and capex.

Since 1996, Johnston has reported an accumulated depreciation charge of £39.6m while spending a total of £52.3m on fixed assets. For the past five years then, cash capex has been 37% higher than the depreciation charge levied against accounting profits.

So rather than use the actual amount of capex spent in 2000, an 'average' ongoing capex figure should lead to a more balanced free cash flow calculation. For Johnston then, adding an extra 37% to its latest depreciation charge gives an 'average' capex figure of £15.8m.

Year to December 2000               (£000)

Pre-tax profit                      66,545
Depreciation                        11,534
Average capital expenditure        (15,822)
                                    62,257

Tax (@ 29.5%)                      (18,366)
Free cash flow                      43,891

So, using this average ongoing capex figure, Johnston's free cash flow for 2000 comes to £43.9m. That figure is some 7% higher than the earlier calculation that used the actual capex amount (£19.9m). I'd say the £43.9m free cash flow figure is a more reasonable and fair estimate than the earlier £41.0m. A more precise definition of my free cash calculation formula would thus be: Profit before tax + depreciation - average ongoing capital expenditure - tax

Summary

Although the alterations for Johnston may seem a little nit-picky, the principle behind the changes is important. While the depreciation charge is designed to help create 'smooth' earnings, business investors have to look beyond accounting niceties. Cash is king. And capital expenditure is a notable drag on most companies' resources.

Although free cash flow is "the measure of cash a company generates over and above what's required to sustain its current competitive position", actually pinpointing the amount spent to sustain that competitive position (as opposed to enhancing it) is nigh on impossible. While there's a fair amount of guesswork and subjectivity involved, assessing a company's free cash flow remains a central plank of long-term investment success.

More: The Free Cash Flow Yield | Analysing Company Reports discussion board

The author owns shares in Johnston Press