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May 24, 2009

Looking for good stock investments? Watch cash flow

David Coffee WCU Book Review

‘Free Cash Flow” is a book about the art of using cash-flow analysis to determine the fundamental value of companies and identify good stock investments.

The book is not appropriate as an introduction to equity investing. It is written for experienced investors with a basic understanding of the concepts embedded in accrual accounting and the conflicting relationship net income measurements based on generally accepted accounting principles, or GAAP, can have with cash flows.

While the focus of the book is narrow, the author offers a surprising number of key insights that can be useful to anyone investing in the stock market.

These insights may very well make this book worth reading, even if you lack a technical financial and accounting background.

While the typical “how to invest” books are written by professional investors or academics in finance, the author, George C. Christy, is neither. Christy, most recently the treasurer of a public company, was for 30 years a corporate banker in Chicago, Tokyo and Los Angeles. His perspective is based on his banking experience.

Because bank loans are “repaid by cash flow, not GAAP earnings,” the author learned early on how to analyze cash flow. After his banking work, he was a consultant at one of the country's largest investor relations firms, writing clients' earnings press releases, annual reports and corporate profiles, and helping CEOs and CFOs prepare for quarterly earnings conference calls and presentations.

Christy's career has given him an insider's perspective of how CEOs and CFOs manage public disclosures and relations with the street.

This book is an insider's perspective on cash-flow investing, which is very different from that of the typical money manager.

Christy characterizes accrual accounting as “the accounting fog machine,” and is critical of the complex array of estimates and assumptions required to generate periodic earnings measurements. He makes a case for using cash flows as a better measure of economic performance.

The importance of cash flows to valuation models is not new, as most valuation models project future cash flows and discount them back to their present value.

The concept of measuring “free cash flows” and using this metric as a basis of economic performance is, as the author points out, widely recognized in the financial community.

Unfortunately, there are several different definitions of free cash flow. Charles Schwab's Schwab Equity Ratings system defines free cash flow as accrual net income plus depreciation and minus capital expenditures and dividends.

Others define it as simply cash flows from operations or cash flows from operations less capital expenditures.

Christy's definition is essentially the latter. But the really important contribution of his book is not his particular definition of free cash flows, but his observations and insight into the importance of how the free cash flows are disposed of and how this disposal affects firm valuation and investor returns.

Christy considers all corporate strategies as falling into one of five possible disposals of free cash flows: cash dividends, share repurchases, debt pay-downs, new capital projects and acquisitions.

It is the disposal of the cash just as much as the generation of the cash that signals good stocks and bad stocks. This point is the key contribution of this book. It certainly made me think about issues I have been overlooking in my own valuation models and portfolio selections.

For example, suppose a company is using cash flow for acquisitions. Christy contends that acquisitions made outside the buyer's core business signal that management thinks its core business offers less than acceptable prospects.

Or suppose a company deploys free cash flows by making share repurchases. The book discusses six types of stock buybacks, one of which is referred to as “delusional buybacks.” These are done by companies with negative cash flows and result in investors owning a larger share of a company's negative cash flow.

Does this spark your interest? Read the book to learn about “nonbuybacks, bonus buybacks, defensive buybacks, front door buybacks and investor buybacks.” Only investor buybacks are good for valuation.

You may visit the author's Web site at www.OakdaleAdvisors.com. If you are a serious equity investor with an analytic perspective, you may find the book to be a refreshing approach to stock selection.

David Coffee is a professor of accounting in the College of Business at Western Carolina University. For previously reviewed books, visit www.wcu.edu/cob.
Additional Facts
About the book

Title: “Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks.” Author: George C. Christy. Publisher: John Wiley & Sons Inc. Length: 181 pages. Price: $49.95. Reading time: 10 hours. Reading rating: 6 (1 = very difficult; 10 = very easy). Overall rating: 3 (1 = average; 4 = outstanding).

First Reviews of Book

Below are the first reviews on the book I have seen. They are on the book’s page on Amazon.com. If you see other reviews, please do not assume I have seen them. Please email them to me so I can post them on the Forum.
Thanks for your help,
George



4.0 out of 5 stars Easy to understand cash flow analysis., May 15, 2009
By Ratatosk (Europe) - See all my reviews
This book is about cash flow analysis with emphasis on how much excess cash is generated by a company, also know as the Free Cash Flow, and which may deviate significantly from the reported Net Income hence revealing that a company is either more or less profitable than its Net Income suggests. For the most part the book is well written and easy to read.

The book was written by a former banker who focused on whether a company generated enough cash to repay its debt. I like that angle and combined with the book's simple language it is the best book for analysing cash flows that I am aware of. The book could however be improved in a few places which is why I haven't given it 5 stars. In particular I would have liked a deeper explanation and discussion of why the author has chosen that particular definition of Free Cash Flow as opposed to other definitions, e.g. why working capital changes are included. I would also have liked a deeper discussion on how to treat debt in the analysis, whether to deduct it or whether one should assume the same debt level could be sustained for eternity.

The book also includes Excel spreadsheets for calculating Free Cash Flow and these are made available for download on the internet. The book gives a long and detailed description on how to complete and interpret these spreadsheets. You will probably skip most of this description on a first reading and only use it for later reference, but it is very good to have when learning to use the techniques for computing Free Cash Flow, and more books in finance should have such detailed descriptions of their methods.

The book is recommended for people already experienced in analysing financial statements. While determined novices may also use this book for learning these things, I do recommend starting out with getting a proper understanding of financial statements first, for example by starting with the book Financial Statements by Thomas Ittelson.
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3.0 out of 5 stars Great investment advice but presented poorly, May 14, 2009
By Queen_Anne_Drizzle (Seattle, WA) - See all my reviews
I agree with most of what Christy writes. Free cash flow is the most important financial metric to follow. Christy points out that free cash flow is important but the smart investor also follows where the money is going. For example, you have to look at dividends, share buybacks, acquisitions and debt. Furthermore, his advice about examining annual reports to evaluate the tone of the CEO, her priorities and executive compensation are all very sound advice.

My problem with the book was its presentation. There is a long chapter in the middle of this fairly short book which ties it to his website. I found it hard to follow and tedious. A book should be stand alone and I did not like being directed to his Excel spreadsheets on his website. Teaching you how to design your own spreadsheets is fine but I did not think that the author did a good job teaching you how to do this through his book. Overall, great wisdom but needs improvement with writing and presentation.
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Corrections

Reader Steve Ching emailed me about an error in Row 53 of the downloadable Free Cash Flow Worksheet on Wiley’s website. Row 53 is supposed to have the year column headings for the Percentages section of the Worksheet, but Row 53 takes the years that you input in Row 2 and spits them out as % numbers! I have given Wiley a corrected Worksheet. Thank you Steve!

Reader Tugrul Avci emailed me about the following errors:

- On page 10, paragraph 2, line 2, the number should be $1 million, not $10 million.

- The footnote number “1” on page 71, line 4, for the reference to the book Creative Cash Flow Reporting is not in the Notes section. Please refer to page 169 in the Recommended Reading section for details on the book.

- On page 83, Exhibit 6.18, cell A134, the correct spelling of “operations” is not “operaions”.

- The number in cell B125 in Exhibit 6.24 on page 91 should be the number that is in the same cell in the Six Restaurants Worksheet: $3,534.8, not $3,552.5

- On page 107, paragraph 2, line 3, “213%” should be “21.3%”.

Thank you Tugrul!

Here are several errors I have found:

- On page 46, in the paragraph directly above “CAPEX: MAGNITUDE AND

RISK”, line 1, the word “obtain” should be between the words “to” and “a

detailed breakdown”.

- On page 148, the “Step 3” title should read “Input Historical Statements into the

Free Cash Flow Worksheet”.

I apologize for these errors and hope they have not caused you difficulty. If you encounter other errors, please email me at gchristy@oakdaleadvisors.com so I can post them on the Forum.

Thank you,

George