A Simple Lesson on Free Cash Flow

• Posted by Robert Sinn
• on June 15th, 2012

As traders we spend a lot of time focusing on charts and technical analysis, however, fundamental analysis is no less important – particularly for longer term investors. One of my first, and most memorable, lessons on the importance of analyzing a company’s free cash flow & operating cash flow came during 2007 when many regional banks were still generating sizeable net income due to large non-cash gains on investments (mortgages etc.) that were clearly turning sour.

Any financial accountant worth his salt will tell you that the cash flow statement is the most important one to look at because it is easy manipulate an income statement or balance sheet but it is much harder to hide a lack of real cash flow. The key takeaway from the 2007-2009 financial crisis was that using reported earnings per share (EPS) to value a financial institution was the height of investing folly. In 2007 many regional banks reported record EPS that were largely due to non-cash gains on mortgage portfolios that were already non-performing, including many banks that counted negative amortization accrual gains as a large part of their net income – most of these banks were filing for bankruptcy or trading below $1/share less than a year later.

@microfundy has a blog post up on “What cash flows to discount when valuing equity” - it is an easy and instructive read which highlights some basic fundamental valuation concepts that can come in handy…..even for technicians. Here’s a quote from Aron:

“For that reason, investors should look at “Free Cash Flow”. Free meaning free to the company – AFTER paying interest on their Debt, & AFTER paying taxes (also not an option to an Equity owner), and even (to be more conservative) take out non-discretionary CAPEX (CAPital EXpenditures which must be made to sustain their current level of business). The only cash flows which should be important to an equity owner is the money that’s left over FOR the SHARE-holders / EQUITY owners.”

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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