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Advanced Fundamental Analysis
Investors use fundamental analysis in an attempt to assess the value of a company. Here, I will discuss some advanced concepts of fundamental analysis.
EV/FCF, FCF/EV
Many investors use the P/E to measure how much a company’s worth. However, the P/E is flawed on many different levels.
The P/E takes the price of what the investors think the company is worth and divides it by the earnings.
Investors who use this ratio make two assumptions:
1) Market capitalization is the value of the company.
2) Earnings is what the company has earned per share for the fiscal year.
The first assumption is generally accepted, however, one should note that the market capitalization is not what it would take to buyout the entire company; it does not take the debt and the cash that the company has into consideration. A value which does is the Enterprise Value (EV).
EV = Market Cap - Cash + Debt
The enterprise value, as the name suggests, is the real value of the enterprise.
The second assumption is true, however, misleading. People use earnings because it’s the number that represents profit. But what is profit? Profit is what is left over after subtracting all costs and expenses from the revenue. The problem is, profit does not necessarily mean that the company has generated cash for the period. What is profit without cash?
Lets answer this question by using an example.
Bob runs a company. At the end of the first fiscal year, Bob generated $100M in revenue. The cost of sales and the expenses were $85M. This means that Bob made a profit of 15M. However, Bob has not paid his suppliers yet and he is obligated to pay 5M to them (A/P). Also, much of his customers bought his products on credit. They are still obligated to pay Bob 30M (A/R).
On the second year, Bob generated 160M in revenue and 24M in profit. The A/P was 10M and A/R was 60M.
Both Bob’s revenues and profit increased by 60% yoy. Not bad at all.
Now lets take a look at his cash flow:
Profit + Changes in A/P - Changes in A/R = $24M + ($10M - $5M) - ($60M - $30M) = ($1M)
While he was making profits, his cash flow was actually negative. Companies cannot run without cash. Therefore, Bob must do something in order to generate some cash flow in the future.
The above is an overly simplified example of how operating cash flow (OCF) works. Here’s the proper equation for it:
OCF = Profit + Depreciation + Changes in A/P - Changes in A/R - Changes in Inventories
Is OCF the cash value that the company can use to pay off its debt, pay for dividends, acquisitions, etc.? Not quite. The cash flow value that can be used for the expansion of business is known as free cash flow (FCF). This value is obtained by subtracting capital expenditures from the OCF. Investors who knew how to use FCF figured out that there was something wrong with ENRON according to its CF statement.
Increasing profit with negative cash flow can create an illusion of a great performing company and too many investors fall for this trap. Investors of KKD, KV Pharma, UTSI, ASCL, etc. all learned this the hard way.
In addition, earnings is a figure that can be easily manipulated by aggressive accounting practices while cash flow is a lot harder to manipulate.
So now you know about EV and FCF. You can now create two simple equations using them.
The first is the EV/FCF. Yes, this is the “true” P/E. The resulting figure tells you that if the company were to pay out its FCF as dividends every year, how long it would take for the company to match your original investment.
The second one is FCF/EV. This one gives you the yield that you earn on the underlying business.
Ok, I’m done for today.
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