Where’s the Cash?

April 4, 2004 • Commentary
This article appeared in Forbes on April 4, 2004.

“Earnings are opinion; cash is a fact.” First recorded in the 1890s, that adage deserves to be etched in bronze above every investor’s desk. And we’re talking not just about net earnings but also about all the modern variations on that figure, such as operating earnings, a.k.a. Ebitda (earnings before interest, taxes, depreciation and amortization). You might think that by focusing on operating earnings, as leveraged‐​buyout meisters are wont to do, you avoid one of the most subjective aspects of net income, namely the rate at which capital expenditures are charged off to earnings as depreciation. But, as Warren Buffett has wisely noted, Ebitda can be even more dangerous than net income because it tempts the investor to think of cap‐​ex as a luxury.

“Among those who talk about Ebitda and those who don’t, there are more frauds among those who do,” Buffett once said. “Either they are trying to con you, or they’re conning themselves.” In the 2003 annual report for Berkshire Hathaway, Buffett defines intrinsic value as “the discounted value of the cash that can be taken out of a business during its remaining life.” Note the word “cash.” That would be cash after necessary levels of capital outlays. If you want to know what FedEx is worth, look at what’s left after it has paid for trucks and airplanes, not before.

Why isn’t the bottom line a good measure of extractable cash? Because so many of the numbers above it in the profitand‐ loss statement are subjective. Depreciation isn’t the only fuzzy number. There are several ways to account for long‐​term contracts, in which payments can run ahead of or behind the work.How should a fluctuating derivative contract be evaluated on the books? In liquid markets you can mark it to recent market value. In illiquid ones you have to “guess.” What is the true cost of your workers’ pensions? A myriad of actuarial and investment judgments determine the answer to that question. The valuation of foreign assets involves assumptions about exchange rates. The treatment of stock options can give the best accountants a headache. Goodwill is yet another accounting issue subject to widely varying opinion. Impairment of long‐​lived assets involves writedowns, but when? Yet another judgment call.

What’s interesting about all these choices is that not a single one changes the balance in the company’s checking account. If you want a fair measure of extractable cash, the ultimate end in running a business, try free cash flow. To get the number, start with “cash flow from operations” shown on the flow‐​of‐​funds page right after the P&L. Now subtract maintenance‐​level cap‐​ex. Absent any clearcut information about which plant and equipment outlays expanded the business and which merely kept existing business alive, assume that all fell into the latter category.

This little exercise won’t guarantee that you will fill your portfolio with the next Microsoft, but it might save you from investing in a WorldCom. Take a look at the chart, which displays Ebitda and free cash flow for the now‐​bankrupt telecom (which has since changed its name to MCI).We measure from 1996 through 2001; the company declared bankruptcy in mid‐ 2002. WorldCom was reporting terrific earnings, but it was somehow always tapped out. Unless you had subpoena power, you couldn’t have determined what was going on—the company was doctoring its P&L by recording ongoing access‐​fee payments as capital outlays. But by looking at free cash flow, you might have been suspicious. Buffett wouldn’t have touched this outfit with a barge pole.

A similar exercise with Adelphia Communications shows Ebitda zooming from $206 million to $1,084 million between March 1996 and December 2000 (date of the last SEC 10-K filing) while free cash flow collapsed from a negative $36 million to a negative $1,649 million. Bid up to $74 a share in January 2000, this is another company now keeping bankruptcy lawyers busy.

I asked Michael Ozanian at FORBES to scroll through the FactSet database for companies with free cash flow per share that has been growing more rapidly than earnings per share during the past three years and currently exceeds earnings per share. Two standouts are Black & Decker and John H. Harland Co. Then he hunted for companies that have recorded double‐​digit earnings growth but whose free cash flow has been falling and whose EPS exceeds FCFPS. Amon g them, Expeditors International ofWashington and Reynolds & Reynolds. You’ve been warned.

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