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Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks
This book shows how to use Free Cash Flow to increase investor return. The author explains the differences between Free Cash Flow and GAAP earnings and lays out the disadvantages of GAAP EPS and the advantages of Free Cash Flow. After taking the reader step-by-step through the author's Free Cash Flow version of the GAAP income statement, the book illustrates with simple formulas how each of the four deployments of Free Cash Flow can enhance or diminish shareholder return. The book applies the conceptual building blocks of Free Cash Flow and investor return to an actual McDonald's. The reader is taken line-by-line through the author's investor return spreadsheet (1) three years of McDonald's historical financial statements are modeled; (2) a one-year projection of McDonald's Free Cash Flow and investor return is modeled. Five companies are compared to McDonald's and each other using both Free Cash Flow and GAAP metrics.
- GenresFinanceAccounting
208 pages, Hardcover
First published July 26, 2006
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Displaying 1 - 2 of 2 reviews
April 12, 2025
- First of all - the author isn’t really a “Cash Flow” fundamentalist per se. But rather, the author (correctly) points out the many short comings of analysts who do not carefully understand a company’s cash flow. Cash flow is merely one of the many important aspects of a company.
- Depreciation is not replacement cost. Depreciation would be best thought as a tax write-off (which, obviously would prefer to be accelerated during an inflationary environment, and stretch as long as possible in a deflationary environment). Replacement cost would be a better calculation to see a company’s cost in business (something Warren Buffett often emphasized as well, in talking about his railroad business)
- To calculate free cash flow, there are 2 steps:
— Step 1) Add back all the non cash expenses (that are accrual), such as depreciation cost, warranty accrual. Then subtract actual cash expenses that was not accrual, such as warranty costs actually incurred and other cash payment. Figures in Step 1 should be easily found throughout the company’s 10-K
— Step 2) Adjust based on the changes of accountings entries. Such as increase in inventory (would subtract that from free cash flow since increase in inventory decreases cash on hand), decrease in receivable (would increase free cash flow since it implies the money is now received by the company), sales of vehicles (would increase free cash flow). Figures in Step 2 should be calculated carefully
- One ought to think of free cash flow as a cushion of management’s management ability. A good manager would have very efficient use of capital, with ample amount of free cash flow as cushion, in addition to ample amount of cash and cash equivalent (as well as short-term, highly liquid investments). Berkshire is a perfect example of this philosophy. Managements that like to play with fire simply use their free cash flow as their tax-free piggy bank, the downside is that should capital market change, the company would be at a very awkward position.
- Under GAAP, under Statement of Cash Flows, underneath the “Operating Activities”, all the noncash items will be removed (what the author calls Type 1) whereas all the cash items not included in the Net Income will either be added or subtracted
- You want lower receivables but higher payables:
Increase in Receivable => Consumed cash (-)
Increase in Payable => Retained Cash (+)
Decreases in Receivable => Obtained Cash (+)
Decreases in Payable => Paid Cash (-)
— Obviously, it’s all situational. Lower receivable and higher payable can also indicate that the company has cash flow problem and is having trouble paying its suppliers
- When inventory increases, it means use of cash (thus cash flow will be reduced for the same amount)
- GAAP accounting essentially gives incentives for companies to boost Capex (thus increase revenue) at the cost of margin (especially when the said company is at its high growth phase)
- Depreciation is not replacement cost. Depreciation would be best thought as a tax write-off (which, obviously would prefer to be accelerated during an inflationary environment, and stretch as long as possible in a deflationary environment). Replacement cost would be a better calculation to see a company’s cost in business (something Warren Buffett often emphasized as well, in talking about his railroad business)
- To calculate free cash flow, there are 2 steps:
— Step 1) Add back all the non cash expenses (that are accrual), such as depreciation cost, warranty accrual. Then subtract actual cash expenses that was not accrual, such as warranty costs actually incurred and other cash payment. Figures in Step 1 should be easily found throughout the company’s 10-K
— Step 2) Adjust based on the changes of accountings entries. Such as increase in inventory (would subtract that from free cash flow since increase in inventory decreases cash on hand), decrease in receivable (would increase free cash flow since it implies the money is now received by the company), sales of vehicles (would increase free cash flow). Figures in Step 2 should be calculated carefully
- One ought to think of free cash flow as a cushion of management’s management ability. A good manager would have very efficient use of capital, with ample amount of free cash flow as cushion, in addition to ample amount of cash and cash equivalent (as well as short-term, highly liquid investments). Berkshire is a perfect example of this philosophy. Managements that like to play with fire simply use their free cash flow as their tax-free piggy bank, the downside is that should capital market change, the company would be at a very awkward position.
- Under GAAP, under Statement of Cash Flows, underneath the “Operating Activities”, all the noncash items will be removed (what the author calls Type 1) whereas all the cash items not included in the Net Income will either be added or subtracted
- You want lower receivables but higher payables:
Increase in Receivable => Consumed cash (-)
Increase in Payable => Retained Cash (+)
Decreases in Receivable => Obtained Cash (+)
Decreases in Payable => Paid Cash (-)
— Obviously, it’s all situational. Lower receivable and higher payable can also indicate that the company has cash flow problem and is having trouble paying its suppliers
- When inventory increases, it means use of cash (thus cash flow will be reduced for the same amount)
- GAAP accounting essentially gives incentives for companies to boost Capex (thus increase revenue) at the cost of margin (especially when the said company is at its high growth phase)
September 13, 2016
The author is something of a cash-flow fundamentalist so leave any affection you have for earnings-based stock analysis at the door. Lots of great insights and ultimately a refreshing no-nonsense approach. I didn't download the tables which the later chapters discuss but thought they sounded interesting and found the walk through useful.
Displaying 1 - 2 of 2 reviews