## Free cash flow, it's applications and how they are calculated

Analysing companies' finances and value from their financial statements using ratios and formulae
TheMotorcycleBoy
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### Free cash flow, it's applications and how they are calculated

Hi,

We are now looking at free cash flow and it's various interpretations and uses. We have gathered that operating profit and cash flow are not the same, and are working out how this can be broken out into useful figures.

One means of breaking down cash flow contributions it seems is as follows:

`Net cash from operationsNet cash from investingNet cash from financing`

these of course added together, yielding an amount equal to the final change in cash, i.e. how much the firm can retain, or how much it must find.

However some of the most useful measures are entities like FCFF (free cash flow for the firm) and FCF (free cash flow for the shareholders). I'm trying to get my head around those as they lead towards my current quest FCFps (free cash flow per share).

Again looking at Phil Oakley's "How to pick quality shares" (pages 45, 76), and again looking at the Dominos example, for 2015, Phil's worked example toward FCFps starts as follows:

`Dominos Free cash flow per share calculation           2015(£m)=================================================================Net CF from operations                                       69.0Capex                                                       [6.8] Dividends from joint ventures                                 0.5-----------------------------------------------------------------Free cash flow to the firm (FCFF)                            62.7-----------------------------------------------------------------......=================================================================`

What I can't understand/justify why (in Phil's DOM example, and presumably this is true in general), is why FCFF isn't calculated as simply this:

`FCFF = Net cash from operations + Net cash from investing`

where in DOMs case from the above year it would leave us a value of less, it would 58 or thereabouts. If you look in the relevant section in the AR for that year (Page 77 of https://investors.dominos.co.uk/system/ ... r-2015.pdf), you can see:

`(figures in £000)=================================================================Net cash generated by operating activities                  68975-----------------------------------------------------------------(Cash flows from investing activities)Interest received                                             191Dividends received from associates                            490 *Decrease in loans to associates and joint ventures            542Decrease in loans to franchisees                             2174Payments to acquire finances lease assets                    [93]Receipts from repayment of franchisee leases                 1288Purchase of property, plant and equipment                  [6763] *Deferred consideration for Domino's leasing limited        [3517]Purchase of other non-current assets                       [5267]......-----------------------------------------------------------------Net cash used by investing activities                     [10995]-----------------------------------------------------------------(Cash inflow before before financing                       58020)......=================================================================`

Putting my question another way "why is it that to arrive at FCFF from Net Cash generated by operating activities we only need to make adjustments (according to Phil's book) due to Dividends received from associates and Purchase of PPE (capex)?". For example, why is an increment for interest received and likewise a decrement for purchase of other NC assets not made?

Whilst, we don't want to make our quest any more difficult than it needs to be (IOW an equivalent FCFF formula using ingredients extracted from a typical AR, would be nice), we do want to get a full grasp of this concept (FCFF) inorder to be able to calculate FCF and then FCFps, apropos future purchases of holdings in other firms.

many thanks, Matt and Mel

PS. this very long url, links to one or two of the relevant pages in Phil's book:
https://books.google.co.uk/books?id=L_7 ... ff&f=false

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### Re: Free cash flow, it's applications and how they are calculated

I'm currently listened to the odd youtube clip, to help me figure out more about this. Currently looking at this

https://www.youtube.com/watch?v=subezRD5B74

at about 3.40 on the white-board, it says:

"FCFF is used to get the value of the FIRM. To get the value of the equity, you must subtract out of the value of the debt"

is that part of our answer? So for FCFF we only need to subtract the cost of immediate capex expenses away from Cash from operations?

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### Re: Free cash flow, it's applications and how they are calculated

Apologies for bombarding this topic with loads of clips and links etc. however if anyone is interested in a similar level of research on this subject as us, I found some value in these, and wanted to share:

https://www.youtube.com/watch?v=wOZvqpqGyLI
https://www.youtube.com/watch?v=fG0C7yz0GSM

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### Re: Free cash flow, it's applications and how they are calculated

Sorry another question, in the consideration of "Cash flow from operations" in any FCFF or FCF calculations, should gross CFO be used or should we use CFO after tax paid?

In Phil's book the DOM example seems to use Net CFO, but a lot of youtube clips I've seen so far, (mainly US and Indian) don't seem to mention tax being applied to this figure.

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### Re: Free cash flow, it's applications and how they are calculated

Melanie wrote:
Whilst, we don't want to make our quest any more difficult than it needs to be (IOW an equivalent FCFF formula using ingredients extracted from a typical AR, would be nice), we do want to get a full grasp of this concept (FCFF) inorder to be able to calculate FCF and then FCFps, apropos future purchases of holdings in other firms.

Hi there,

This very interesting topic (FCF), has cropped up a number of times over the years, and a lot of interest was generated back in the TMF days over a period of time that I think might do you some good to review.

Here's a link to a recent thread discussing some archive links for you to take a look at, and below it a link to an online Google-Docs spreadsheet that was set up to help calculate FCFF, using worked exampkes of real-world company-results -

viewtopic.php?f=15&t=5831&p=61186#p61186

https://docs.google.com/spreadsheets/d/ ... n_GB#gid=0

This is a subject that's close to my heart, given its importance in allowing a company to continue paying good and rising dividends, so any feedback regarding the avove links would be most appreciated, especially to hear if the information contained in them aligns with your current reading of the topic.

Cheers,

Itsallaguess

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### Re: Free cash flow, it's applications and how they are calculated

Thanks Itsallaguess,

I haven't come to any firm conclusions as to how to extract useful figures (e.g. FCFps) in a generic way from ARs. Given the variation in presentation of ARs I suspect there is no such way, and hence CF calculations must be open to interpretation.

I haven't not learnt a great deal more since yesterday, except that the CFO must be the net figure. And the point which is starting to resonate is that overall these calculations, are trying to value a firm (not wishing to state the obvious)....

this point was hammered home, more when I listened to this in more depth:
https://www.youtube.com/watch?v=fG0C7yz0GSM

i.e. the CF of a firm is it's value, and leading on to:

`Value_of_firm = Value_of_debt + Value_of_equity`

and this informed me as to why we need to subtract interest charges (and preference share divs) from FCFF before arriving at FCFE.

Whilst the youtube I linked above was useful, I was unnerved by frequent reference to (1 - t), since I then wonder what value I should be using for t, i.e. is a generic value or something which will be somewhere in the AR?

Matt

(PS thanks for the links you quoted!)

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### Re: Free cash flow, it's applications and how they are calculated

Melanie wrote:
Whilst the youtube I linked above was useful, I was unnerved by frequent reference to (1 - t), since I then wonder what value I should be using for t, i.e. is a generic value or something which will be somewhere in the AR?

Hi Matt,

't' is likely to be the 'effective tax rate', and is usually stated in the results.

From the Severfield Rowan RNS linked to on the GoogleDocs sheet, we can see the following -

Taxation

The underlying tax charge of £14.4 million represents an effective tax rate of 28.9% compared with 28.7% in the previous year. This rate is slightly higher than the prevailing rate of 28% due to the adjustments made in respect of disallowable expenditure incurred during the year.

https://www.investegate.co.uk/Article.a ... 700089696I

So, on the GoogleDocs example linked earlier (https://tinyurl.com/y99qwbrh), you can see the the effective tax rate that's used is the 28.9% figure disclosed by the company above.

Some quick links on the following page that gives some guidance for the various FCF calculations - https://ycharts.com/glossary/terms/free_cash_flow_firm

Cheers,

Itsallaguess

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### Re: Free cash flow, it's applications and how they are calculated

Itsallaguess wrote:'t' is likely to be the 'effective tax rate', and is usually stated in the results.
Thanks,
Yes I thought as much. My main issue with calculating FCF figures is that is seems difficult to find any corrobarating data elsewhere which convincingly confirms/disproves one's own result.

Mel and I have spent some of the day looking at some figures for NEXT, in the year up to y/e Jan 2018 (IOW 2017), from this resource:
http://www.nextplc.co.uk/~/media/Files/ ... n-2018.pdf

`NEXT====2017(y/e jan 2018) (figures in GBPm, unless stated otherwise)================================================================================Income======Revenue  4,055.5op prof  759.9-less interest costsint      [33.8]PBT      726.1PAT      591.8Weighted av. of share issue 142 Million sharesSo EPS = 591.8 / 142 = £4.17 per share================================================================================Cash flow statement===================op prof 759.9net CFO 615.2capex [112.2]So Net CFO - Capex = FCF=> FCF = 503.0 =============borrowings 135.0  int paid/recv [32.1] To find FCFE we subtracted the cost of debt (interest) and added on extra leverage onto FCF=> FCFE = 605.9FCFps = 605.9 / 142 = £4.27 per share=================================================================================`

We went over our logic, and working out, and we think what we have done is more or less right. It's not wildly off Phil's Oakley method, and it has some parity with EPS. However we compared our calculation with that on 4-traders, we noted a difference.

http://www.4-traders.com/NEXT-9590100/financials/

They said £4.82 per share. I'm starting to go off 4-traders......

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### Re: Free cash flow, it's applications and how they are calculated

Melanie wrote:To find FCFE we subtracted the cost of debt (interest) and added on extra leverage onto FCF
=> FCFE = 605.9

FCFps = 605.9 / 142 = £4.27 per share
=================================================================================[/pre]
We went over our logic, and working out, and we think what we have done is more or less right. It's not wildly off Phil's Oakley method, and it has some parity with EPS. However we compared our calculation with that on 4-traders, we noted a difference.

http://www.4-traders.com/NEXT-9590100/financials/

They said £4.82 per share. I'm starting to go off 4-traders......

Matt & Mel,

I would not trust any numbers from free websites tbh. If you're a serious investor you need an accurate source of data on which to base your investment decisions, and most of these sources calculate ratios like ROCE, ROE, FCFps etc. for you. I would recommend you consider subscribing to Stockopedia (Thomson-Reuters data) or Sharepad (Morningstar data + the home of Phil Oakley). I guess you're both on the path to being serious investors given the amount of time you are spending reading books and analysing company accounts.

In terms of the Next FCF numbers, as with other ratios, there are slightly different methods possible. The numbers I have for Next 2017 FCFfps are 358.8p on Stockopedia and 352.8p on Sharepad, so there is a 6p difference in the numbers for some reason! This could be caused by the number of shares used i.e. one source may use the number of shares at the end of the year and another the average number of shares, which are not the same as Next was doing buybacks.

Hope this helps!
Si

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### Re: Free cash flow, it's applications and how they are calculated

Hi Simon,

Indeed we are circumspect about the figures quoted by the free sites. I am happy to calculate the figures though from ARs - but was curious as to how well they compared. It does not take a massive amount of time, and IMO, is more worthwhile for us to this as opposed to subscribe to sharepad or likewise.

Personally I dubious about the figures you quoted from sharepad and stockopedia, though I'm certainly not an expert!

FWIW our figure is v. close to that quoted by morningstar....
http://financials.morningstar.com/ratio ... region=gbr
(they quote £4.33/share vs my figure of £4.27/share

I calculated the Next 2017 FCFps, by reference to the "52 weeks to Jan 2018" from here:
http://www.nextplc.co.uk/~/media/Files/ ... n-2018.pdf

I'm not sure exactly how make our figures any different, and whilst FCF calculation, in my opinion is more complex than that of ROCE, I'm fairly confident that I correctly applied what I've read from Phil's book, which also seems in accord with:

https://en.wikipedia.org/wiki/Free_cash ... ve_formula

thanks again, Matt

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### Re: Free cash flow, it's applications and how they are calculated

Melanie wrote:Personally I dubious about the figures you quoted from sharepad and stockopedia, though I'm certainly not an expert!

FWIW our figure is v. close to that quoted by morningstar....
http://financials.morningstar.com/ratio ... region=gbr
(they quote £4.33/share vs my figure of £4.27/share

thanks again, Matt

Matt,

Well, I don't understand what number of shares the Morningstar calculation is using? It looks wrong to me! How can they show FCF of £502m in one row and then in the row below show FCFps as 433p? That means they have used 116m as the number of shares, which is clearly incorrect so something does not add up. I can see all the working for the Sharepad number (FCFfps = 352.8p) and it looks correct to me as they have FCFf of £502.4m and use 142.4m shares. FWIW they show FCFe as 470.3m or 330.3p per share, once £32.1m interest is taken into account.

All the best, Si

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### Re: Free cash flow, it's applications and how they are calculated

Matt,

OK. I've just sussed the difference is caused by adding in net borrowing of £135m to get the FCFe figure. I've never seen that done before and even the Wiki page you linked to calls it the Alternative method. I'll stick to the traditional method which is consistent with Sharepad and Phil Oakley's calculation described in P48 of his book. As I've said before, decide on your own method and stick to it, the only rule if you're going to use a ratio for comparison is to be consistent in how you calculate it!

All the best, Si

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### Re: Free cash flow, it's applications and how they are calculated

I know. So many different ways to interpret / calculate a figure. Yes the addition of net borrowing does slew the figures.

I suppose these figures all prove that a firm's health/activities etc. cannot really be captured particularly easily, since they are based on processing ARs, which:

1. Are just snapshots taken at yearly intervals.
2. Presumably, the FD will bias the figures to cast the best on the company.

So....I guess, the approaches on offer, least in my opinion, are either ignore the figures and go with your gut feelings or view a good few years worth of consistently measured figures - in the hope that the firm cannot lie forever!!

Matt

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### Re: Free cash flow, it's applications and how they are calculated

Melanie wrote:
So....I guess, the approaches on offer, least in my opinion, are either ignore the figures and go with your gut feelings or view a good few years worth of consistently measured figures - in the hope that the firm cannot lie forever!!

I think FCF trends and consistency are just as important as the actual FCF figures themselves sometimes, so that's certainly an area that I find interests me.

Interesting thread Matt, so thanks for sticking with it and teasing out some of these issues.

Cheers,

Itsallaguess

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### Re: Free cash flow, it's applications and how they are calculated

Melanie wrote:So....I guess, the approaches on offer, least in my opinion, are either ignore the figures and go with your gut feelings or view a good few years worth of consistently measured figures - in the hope that the firm cannot lie forever!!
Matt

For the avoidance of doubt... Never ignore the numbers! That's all you've got to go on that is factual (assuming the company is not a fraud). If you want to lose money on shares, ignoring the accounts is one of the best ways to do it because you're results will then be entirely dependent on luck and you may as well join the HYP fraternity (strategic ignorance). Gut feelings are a factor in judging things like management quality, but not as important as the numbers and keeping an eye on general industry trends.

Good luck whatever you decide to do.
All the best, Si

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### Re: Free cash flow, it's applications and how they are calculated

simoan wrote:For the avoidance of doubt... Never ignore the numbers! That's all you've got to go on that is factual (assuming the company is not a fraud).
Cripes no!

Whenever I try to rely on "just luck" or "gut feel", something usually goes wrong! Consideration of underlying numbers, whether we obtain them online or calculate ourselves, is going to play a major role in how me and Mel invest.

In all honesty we will try to use a combination of our calculations and online stats, and as Itsallaguess suggests, be mindful of trends and consistency.

simoan wrote:the HYP fraternity
What exactly do you mean by this? Is this just aiming for big dividend paying companies and missing/ignoring any weaknesses which may be lurking within?

thanks Matt

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### Re: Free cash flow, it's applications and how they are calculated

Melanie wrote:
simoan wrote:For the avoidance of doubt... Never ignore the numbers! That's all you've got to go on that is factual (assuming the company is not a fraud).
Cripes no!

Whenever I try to rely on "just luck" or "gut feel", something usually goes wrong! Consideration of underlying numbers, whether we obtain them online or calculate ourselves, is going to play a major role in how me and Mel invest.

Glad to hear it. You had me worried there for a minute!

Melanie wrote:
simoan wrote:the HYP fraternity
What exactly do you mean by this? Is this just aiming for big dividend paying companies and missing/ignoring any weaknesses which may be lurking within?

Let's not go there! There are separate boards for HYP that you can read if you wish to employ "strategic ignorance". Let's just say it's a more high level approach based on income rather than capital appreciation, achieved through buying high dividend paying shares, as you mention. It's very popular on Lemonfool but it doesn't involve reading accounts necessarily, which is just as well, because most typical HYP shares have the most unintelligible accounts possible

All the best, Si

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### Re: Free cash flow, it's applications and how they are calculated

simoan wrote:
If you want to lose money on shares, ignoring the accounts is one of the best ways to do it because you're results will then be entirely dependent on luck and you may as well join the HYP fraternity (strategic ignorance).

Without wishing to derail an interesting thread, I think this is overplaying the anti-HYP card somewhat.

It's really quite possible to own a High Yield Portfolio at the same time as also taking a keen interest in the underlying accounts of the companies themselves. The two things aren't mutually exclusive, you know...

In fact I think I've probably seen more 'under-the-bonnet' discussions on The Lemon Fool in the past couple of years regarding this type of more forensic study of HYP candidates than I did for many years at the end of TMF's days, and long may that continue.

But even at a vanilla-HYP level, I'd go so far as saying that it's simply untrue that people interested running a HYP 'ignore the accounts', as there are lots of metrics discussed with HYP candidates that prove otherwise, such as dividend-cover, free-cash-flow, debt, etc.

Of course some investors will often take punts on HYP shares without taking an interest in the underlying businesses or their accounts, but I really don't see that as being any different to some value-investors taking punts, or similarly some investors using other strategies.

I also think that trying to align the phrase 'strategic ignorance' with a potential to ignore the accounts side of things is a misnomer. The two are completely separate issues, I think.

Cheers,

Itsallaguess

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### Re: Free cash flow, it's applications and how they are calculated

Itsallaguess wrote:
simoan wrote:
If you want to lose money on shares, ignoring the accounts is one of the best ways to do it because you're results will then be entirely dependent on luck and you may as well join the HYP fraternity (strategic ignorance).

Without wishing to derail an interesting thread, I think this is overplaying the anti-HYP card somewhat...

Itsallaguess

For the avoidance of doubt, none of my comments were intended as anti HYP, although "strategic ignorance" was always a key part of Pyad's selling point from what I recall? However, I agree, let's not derail this otherwise interesting thread by discussing the HYP approach - there's plenty of discussion of it elsewhere, and so I will not be making any further comment as I don't wish to get involved in a discussion about it .

All the best, Si

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### Re: Free cash flow, it's applications and how they are calculated

simoan wrote:For the avoidance of doubt, none of my comments were intended as anti HYP, although "strategic ignorance" was always a key part of Pyad's selling point from what I recall?

Always? Find a reference to it in his initial articles on HYPs (https://web.archive.org/web/20140219210 ... 01106c.htm and https://web.archive.org/web/20140528041 ... 01113c.htm) and I might agree with you...

For the sake of trying to avoid a potential further unnecessary detour from this board's subject, from you or anyone else: yes, those articles do contain some comments about not "meddling" (more usually known nowadays as "tinkering" on the HYP board) - i.e. pyad's idea of not considering selling. But that's quite different from his idea of "strategic ignorance", which is to deliberately ignore anyone's views (including one's own) about the long-term future of a company.

And by the way, I'm not commenting here either to defend or attack those ideas - I just want clarity about what they are. I'm very doubtful about the idea that "strategic ignorance" has ever been a selling point of the HYP strategy - I get the impression from comments on the boards that it's put off far more people than it's attracted. But the idea that it's always been such a selling point strikes me as demonstrably wrong rather than merely my subjective impression, given its total absence at the start!

simoan wrote:However, I agree, let's not derail this otherwise interesting thread by discussing the HYP approach - there's plenty of discussion of it elsewhere, and so I will not be making any further comment as I don't wish to get involved in a discussion about it .

Well, if you don't want to get involved in a discussion about something, I'd seriously recommend not taking potshots at it!

Edit: And by the way, your original potshot that "ignoring the accounts is one of the best ways to do it because you're results will then be entirely dependent on luck and you may as well join the HYP fraternity (strategic ignorance)" was completely off-target. Ignoring views on the long-term future of companies does not mean "ignore the accounts" - not unless you have a working time machine and so can access the company's future accounts!

Gengulphus

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