Where’s the Cash?

This article appeared in Forbes on April 4, 2004.
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"Earnings are opinion; cash is a fact." Firstrecorded in the 1890s, that adage deserves to be etchedin bronze above every investor's desk. And we're talkingnot just about net earnings but also about all themodern variations on that figure, such as operatingearnings, a.k.a. Ebitda (earnings before interest, taxes, depreciationand amortization). You might think that by focusing onoperating earnings, as leveraged-buyout meisters are wont todo, you avoid one of the most subjective aspects of net income,namely the rate at which capital expenditures are charged off toearnings as depreciation. But, as Warren Buffett has wiselynoted, Ebitda can be even more dangerous than net incomebecause 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 thecash that can be taken out of a business during its remaininglife." Note the word "cash." That would be cash after necessary levels of capital outlays. If you want to know what FedEx isworth, look at what's left after it has paid for trucks and airplanes,not before.

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Why isn't the bottom line a good measure of extractablecash? Because so many of the numbers above it in the profitand-loss statement are subjective. Depreciation isn't the onlyfuzzy number. There are several ways to account for long-termcontracts, in which payments can run ahead of or behind thework.How should a fluctuating derivative contract be evaluatedon the books? In liquid markets you can mark it to recent marketvalue. In illiquid ones you have to "guess." What is the truecost of your workers' pensions? A myriad of actuarial andinvestment judgments determine the answer to that question.The valuation of foreign assets involves assumptions aboutexchange rates. The treatment of stock options can give the bestaccountants a headache. Goodwill is yet another accounting issue subject towidely varying opinion. Impairmentof long-lived assetsinvolves writedowns, but when?Yet another judgment call.

What's interesting about allthese choices is that not a singleone changes the balance in thecompany's checking account. Ifyou want a fair measure ofextractable cash, the ultimateend in running a business, tryfree cash flow. To get the number, start with "cash flow fromoperations" shown on the flow-of-funds page right after theP&L. Now subtract maintenance-level cap-ex. Absent any clearcutinformation about which plant and equipment outlaysexpanded the business and which merely kept existing businessalive, assume that all fell into the latter category.

This little exercise won't guarantee that you will fill yourportfolio with the next Microsoft, but it might save you frominvesting in a WorldCom. Take a look at the chart, which displaysEbitda and free cash flow for the now-bankrupt telecom(which has since changed its name to MCI).We measure from1996 through 2001; the company declared bankruptcy in mid-2002. WorldCom was reporting terrific earnings, but it wassomehow always tapped out. Unless you had subpoena power,you couldn't have determined what was going on—the companywas doctoring its P&L by recording ongoing access-feepayments as capital outlays. But by looking at free cash flow,you might have been suspicious. Buffett wouldn't have touchedthis outfit with a barge pole.

A similar exercise with Adelphia Communications showsEbitda zooming from $206 million to $1,084 million betweenMarch 1996 and December 2000 (date of the last SEC 10-K filing)while free cash flow collapsed from a negative $36 million to anegative $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 theFactSet database for companies with free cash flow per sharethat has been growing more rapidly than earnings per shareduring the past three years and currently exceeds earningsper share. Two standouts are Black & Decker and John H.Harland Co. Then he hunted for companies that haverecorded double-digit earnings growth but whose free cashflow has been falling and whose EPS exceeds FCFPS. Amon gthem, Expeditors International ofWashington and Reynolds& Reynolds. You've been warned.