No matter how long you’ve been investing, there will inevitably come a time when you ask yourself if there’s a financial metric that is better than the others. What financial metrics can do is to help you to put a number on the value of a company.
So the question is, how do you find the best financial metric for your taste? If it’s already popular by other investors, you should also be able to use them, right?
Here are my 10 preferred financial metrics (listen in no particular order):
Today I’ve been talking about my favourite financial metrics. Have I missed any? Leave your comments below!
Today I want to talk about the Free cash flow yield and discuss why it is important for value investors.
In theory value investing is easy.
You buy an undervalued stock, you reinvest the dividends and you repeat for a long time.
The trouble is that you cannot be certain when the stocks that you are looking at are really undervalued – perhaps the company had just one year of good earnings that skews the Price to earnings ratio.
That is why I prefer to look at the Free cash flow. The Free cash flow is the amount of money that the company is making after paying off costs to maintain or expand the company’s asset base.
The Free cash flow is the money that the company can spend to pay dividends or to buy back shares.
Quite a lot, it turns out.
The Free cash flow per share complements the earnings per share and gives a broader picture of the money made.
Because it cannot be as easily manipulated as the earnings per share, it gives a fairer picture of how much money that flows into the company.
First of all you need to find the Free cash flow. Go to the company’s web site and download the most recent annual report.
In there you will find something that is called Comprehensive cash flow statement.
You take the Cash flow from operating activities and you enter it into Excel. Then you will find something called Investment in plant, property and equipment. Then finally you add the two together, like so:
Then you need to find the number of shares that the company has outstanding and you divide the Free cash flow with this number.
Then it turns out that the Free cash flow yield is easy:
You divide the Free cash flow per share with the price per share, like so:
What you end up with is a percentage that you can use as a valuation metric.
In my experience, a free cash flow yield above 5 per cent indicates that the share is undervalued, if it is between 3 and 5 per cent it is worth considering and if it is below 3 per cent the share is outright expensive.
That is the reason why you want to consider the Free cash flow yield as another value metric.
Why not give it a go?
Pepsico is valued at 26.5 times 2016 earnings which is expensive. If we assume that the company will be making $4.50 this year, which is in line with what they’ve been earning so far in 2017, the P/E ratio comes in at 25.7 which is still very expensive. The P/E over the past three years’ earnings is 28.2.
The Free cash flow yield comes in at 4.4 per cent which qualifies the stock in the “watch” category.
The only reason why you would want to own such a stock is the dividend of $3.06 per share (2.6 per cent yield). In an environment where you are getting 2.17% on a 10-year note this may be interesting for some people. However, as it stands the stock is too expensive for me.
The day after publishing this we figured out that the company presented their earnings.
The earnings came in better than anticipated and we can now make estimated guesses for next year’s earnings.
We think they will come in around $4.50 per share which equates to a forward P/E of 25.3.
That is still far too expensive for my taste.
Yesterday interestingly the share went down 0.5 per cent to $113.74.
At $115 and a trailing P/E value of 26.5 the PepsiCo share is expensive. Over a period of three years, the P/E ratio is even higher at 28.2. Because of their high degree of intangible assets the Book value is negative so a measure like Price to book does not make sense.
PepsiCo has a Working capital of $6 billion but the Working capital to debt is low at only 0.1. The Debt to equity ratio is extraordinarily high at 5.6.
In all, PepsiCo’s balance sheet could look better.
The company has a Free cash flow of $7.4 billion which equates to $5 per share. Of this they both buy back outstanding shares and pay a good dividend of $2.96 (2.6 per cent). The earnings look stable.
PepsiCo has been paying out uninterrupted and increasing dividends for more than 25 consecutive years.
At 26.5 times trailing earnings PepsiCo is too expensive for my taste. At these prices I would call it a SELL.
Fundamental analysis of McDonald’s (MCD), June 24, 2017
McDonald’s is marginally more expensive since the last update. The company is now valued at 29.2 times 2016 earnings. The price over the average three years’ earnings is 31.7 which is way too much.
To be a serious buyer of the company I would like to see prices drop with at least 50 per cent.
McDonald’s had an earnings call yesterday and even if they had a reduction in sales last quarter compared to the same quarter last year of 3.5 per cent, they managed to increase their earnings per share by 30 per cent. The current earnings per share is $1.70.
The current P/E ratio is still very high at 28.9 with a forward P/E ratio of 26.2. The Book value is negative due to the high proportion of intangible assets.
If you buy the stock now, you believe that their earnings will continue to grow indefinitely.
It doesn’t make sense to buy McDonald’s stock at these prices.
McDonald’s is not a small-cap stock, but nevertheless a value proposition that fits into this article.
The company is one of the world’s leading fast food chains with more than 36,000 restaurants around the world.
McDonald’s is not cheap at 28.4 times earnings. Average earnings of the past three years come in at 5.02 which gives a P/E ratio of 30.8. Because of the high Goodwill, the Book value is negative. The company has $1.4 billion in Working capital which means that it is able to pay its short-term bills.
The company has a negative equity which in theory means that a shareholder owes money to creditors if the company goes bankrupt. This does not look good.
McDonald’s has a Free cash flow of $4.2bn which allows the company to pay out a nice dividend of $3.61 per share. Furthermore, the company is part of the Dividend Aristocrats which means that they have paid out uninterrupted and increasing dividends over the past 20 years. The dividend yield, on the other hand, is low at 2.3%.
At $154.64 the McDonald’s stock is too expensive for me.
What does it take to say no?
As an investor, you are more likely than not to have been in a situation like this:
You are listening to a presentation of a company that you are interested in.
The CEO is making his pitch and it is tempting. The business model sounds fool proof and you are on the verge of buying equity in the company.
But is it a good idea to buy just when you’ve listened to a presentation with a CEO?
Of course it is not. As always, you owe yourself some due diligence before making any investment decisions.
That is why I advice you to wait a week before buying if you’re tempted. If by then, it’s still a good proposition then buy. Otherwise you say no.
As famous investor Benjamin Graham once said:
Every investment decision should be taken with safety of principal and a good rate of return in mind.
In the example above, the safety of principal is to say the least dubious.
There is simply no guarantee that you will be able to get your money back if you invest in an “interesting startup”. Additionally, the rate of return will almost certainly be non-existent in a speculation like this.
You don’t want to go there.
You need to take an ice cold look at the prospect and not letting your feelings run high.
You need to carefully analyze the investment proposition looking at different key numbers from both the company in question and competing companies.
One thing that is extremely important is the earnings where a good investment is characterized by solid earnings. It makes no sense to invest in a company that is loss making.
If you after careful analysis come up with a negative outlook for the company, then you owe yourself to say no.
The more you look at different companies, the more experience you will acquire.
What that means is that you will look at many investment propositions before finally acting on one or two.
You will then be more secure in your decisions and not waste any money on useless propositions.
Fundamental analysis of Target Corporation (TGT), July 17, 2017
Target is valued at 11.6 times 2016 earnings which is cheap enough to make it interesting. If we assume that the company will make $4.50 for the whole of 2017 – which is in line with the earnings reported so far – the P/E ratio comes in at 12.1. This number is not cheap, but not extremely expensive either.
The problem is of course that it is a retailer – a business model that is under heavy attack from e-commerce competitors. However, for the time being Target is making real money which potentially makes it an interesting value proposition.
Target Corporation operates a household retail business in the United States. It is based in Minneapolis, MN.
Given the strength of its business, the company is reasonably priced at 11.5 times earnings. Average earnings over the past three years are low with one year of loss. Price to forward earnings comes in at 11.8.
Price to book value is high at 2.9.
The earnings history seems a little bit erratic with 2014 being a year with a loss. They actually lost $1.6 billion that year which equates to a loss of $2.56 per share. Hopefully, Target Corporation will stay away from those years in the future.
The company’s current liabilities are greater than its current assets so the net working capital is negative.
The Debt to equity ratio is 2.4, a number which usually is associated with high risk.
The company last year had a Free cash flow of $3.9 billion which equates to $6.70 per share. Of this they are paying out a dividend of $2.36 (2.8%).
Because the company is reasonably priced, I’m tempted to dip my toes in the company. The only problem is the high debt levels.
Walgreen Boots is valued at 21 times last year’s earnings. If we assume that the company will make $4.00 in 2017, the forward P/E ratio comes in at 20.
Because the company has a lot of intangible assets the Price to Book comes in at 19.7, which is very high.
In summary, I would not buy shares in Walgreen Boots at this time.
Walgreen Boots Alliance is an American pharmacy chain with many business areas in the health sector.
At $78 and a trailing P/E of 20.3, the company is expensive. Looking at an average of the past three years’ earnings, the P/E comes in at 23.7 which is not better. Because of their intangible assets the Price to Book value is also very high at 19.0.
The company has a Debt to equity ratio of 1.4 and a Working capital to debt ratio of 0.2 which is OK, but not extraordinary. The Net working capital is $8.9 bn which of course is a lot of cash.
Last year, the Return on equity was 14 per cent which was OK, but not extraordinary. A high Return on equity usually correlates with a high Free cash flow.
Last year Walgreen Boots had a Free cash flow of $6.5 bn which allows them to buy back a lot of the expensive shares that they have issued.
It also allows them to pay a dividend of 1.46 (1.9 per cent). The dividend has been uninterrupted and increasing for at least 25 years.
The company is too expensive at these prices. Ideally I would like to see them fall by 50 per cent before dipping my toes.
There is nothing wrong with the company, but it is simply too expensive.
Fundamental analysis of Leggett & Platt Inc., June 2, 2017
Leggett & Platt is neither expensive nor cheap at 16.8 times the earnings of 2016. Assuming forward earnings of $2.50 for 2017, the forward P/E ratio is 18.6 which is on the high side. I would not be a buyer of the stock at these prices.
Leggett & Platt is a designer and manufacturer of home and office products. It has its headquarters in Carthage, Missouri.
Leggett & Platt seems expensive at a trailing P/E of 19.0. Over the average past three years the P/E is even worse at 27.6. The Shiller P/E is very high at 46.7. Given the high amount of intangible assets the company’s Price to book ratio is very high at 53.3.
With a Working capital of $620m seems well capitalized. At least they don’t have any problems with paying their short-term bills. However the company has a Debt to equity ratio of 1.7, a figure associated with high risk. Net earnings to sales in 2016 came in at 10.3 per cent which is good for a manufacturing company. Last year’s Return on equity was very high at 35 per cent.
Leggett & Platt has a Free cash flow of $430m which equates to $3 per share. Of this the company pays out a dividend of $1.12 (2.5%) which seems reasonable.
Leggett & Platt is a well run company with solid earnings and good cash flow. However, at these prices I would not buy new stock.
This time we will look a bit more in depth on how to use Microsoft Excel for financial calculations.
What we will look at today is Financial statements and how to use them in order to understand the financial health of a company.
In particular we will look at:
The first thing to grasp is that we will look at the numbers and look at them through the eyes of people in finance.
They use the numbers differently than the people in accounting and we will show you how.
In the last article we talked about this formula:
Assets = Liabilities + Equity
Everyone in finance is using this equation and not just in finance but also in accounting.
What the Balance sheet does is that it reflects the equation.
The Balance sheet is a snapshot of the Firm’s account balances at the last day of the reporting period.
The assets are divided into Current assets and Non-current assets where the Current portion is assets that can be turned into cash within 12 months.
Then per definition Cash is a Current asset. Then we Accounts receivable which is accounts that will be cash soon. Inventory is another Current asset. The whole point of inventory is so that you can sell it and get cash.
The Current assets are important not only in finance, but also in accounting, auditing and banking. It’s very important to see a business’ Current assets, because if they don’t have very many current assets perhaps they cannot pay their bills.
The Non-current portion are fixed assets that cannot be easily transformed into cash. These are your buildings, your trucks or patents or the long-term assets that actually define your business.
This is what you’ve invested in because you think you can make a profit from this.
In a financial statement you will see different periods. That is because you want to compare one year’s numbers to another.
We will also talk about the other side of the equation, which are the liabilities. These are the funds that the company have at its disposal.
The company either goes out and get debt (current), it borrows money long-term (bonds) or it issues equity to get its funds which means the cash it is going to use to buy its assets.
Current liabilities are liabilities that need to be reimbursed within a year – much like the current assets which are assets that can be converted into cash within a year.
Current liabilities are the bills the company need to pay within one year.
As you can see, within the current liabilities there are two items Accounts payable and Notes payable.
Accounts payable is when the company goes out and buys products that it has to pay for. Notes payable is when the company borrows money that it has to reimburse within a year.
The combined current liabilities and non-current liabilities represent debt on the balance sheet.
In cell A19 you can see that we’ve written Common stock and paid-in surplus. What that means is that if the company issues common stock and they are being priced at $22 but were supposed only to be worth $20, the paid-in surplus is the $2 that the stockholders pay in order to own the company.
Retained earnings belong to the shareholders and they are to be paid back to the shareholders in the form of dividends, but sometimes they are not.
If they are not paid out to the shareholders they can be used within the company in the form of investment.
The way to account for such a situation is to label the item Retained earnings.
Finally we add it all up. First we calculate total liabilities which is the sum between current and non-current liabilities.
Then we calculate total liabilities plus shareholders’ equity which is just what it sounds like.
Why is it called the Balance sheet?
That’s because there’s an equal sign in the formula Asset = Liabilities + Equity which means that the two sides have to balance each other.
So what I do in cell B24 (Figure 2) is that I add the total assets from Figure 1 in cell B18 and in cell C24 (Figure 2) I add the Total liabilities and Shareholders’ equity from cell B22:
The result that we get in D24 is then TRUE.
Remember that Current assets are assets that the firm easily can convert into cash and that the Current liabilities are the bills that the company needs to pay within 12 months.
If your current liabilities are greater than your current assets it means you’re in trouble and you need to find cash somehow.
The Net working capital is the term that is used and it is defined as Current assets – Current liabilities.
The Net working capital is the short-term capital that the firm has to work with.
We will use the Net working capital when we do our cash flow calculations and we will also use it in the next chapter when we do analysis of financial statements.
In accounting you will see that the term Net working capital is used but in finance the term Capital is used more broadly for all assets.
If we now have our Current assets and Current liabilities on different sheets like this:
If we now want to calculate the Net working capital we do it like this:
In the sheet Working capital we type an equal sign in cell D16.
We then click on the sheet Assets in Figure 5. and we click on Current assets (cell B13):
If we look in the formula bar in Figure 7 we see that we have now activated cell B13 in the sheet called Assets. The exclamation sign means that we are using a different sheet for our data.
We then type a “-“-sign (1) and click on the “liabilities”-sheet (2) in Figure 5:
Then we click in cell B16 and hit Enter and we are immediately brought back to the Working capital sheet.
What’s important to remember here is not to click on Working capital sheet but rather hit Enter (if you don’t hit Enter your formula will be ruined).
If we then go back to the Working capital sheet and hit the F2 key, this will appear:
Of course, different businesses have different values for their Net working capital, but in general, the number should be positive.
We will then turn our attention to Liquidity:
Liquidity is important because if you run out of it you’re in trouble.
If your working capital is getting too small then maybe you have to sell assets to get cash for the company.
Liquidity is defined as:
How quickly an asset can be converted into cash.
Furthermore, liquidity has two dimensions:
There are highly liquid assets which can be sold quickly without loss of value. (This can be inventory or a short-term investment).
How liquid is cash? That is the most liquid.
How liquid is accounts receivable? You can quite easily convert accounts receivable into cash. In fact you can sell those assets to bank and get cash in return.
The we have illiquid assets which are assets that cannot be sold quickly without significant price reduction. Examples of this are machinery and buildings.
You can almost sell anything if you reduce the price enough.
On the Balance sheet the items are usually listed in decreasing liquidity so that the most liquid assets come first.
Another aspect of liquidity is that businesses that have it can go out and get a loan easily.
A firm needs a positive working capital in order to pay its bills, but there is another aspect to it:
The reason why a lot of companies are keeping a lot of cash on their balance sheets is so that they can go out and buy other businesses quickly.
The last point is that you probably don’t want to have too much cash on your balance sheet because it doesn’t earn any return.
We will then turn our attention to building a balance sheet:
The first thing that we want to look at is assets. What I do is that I type en equal sign in cell B10 and then I write SUM( and I highlight cells B7 and B8:
Then we do the same thing for the liabilities in cell E7 and E8:
The result in E10 will of course be $550.
How are we then going to calculate the equity? If you remember the fundamental accounting equation:
Assets = Liabilities + Equity
In other words:
Equity = Assets – Liabilities
So what we do is that we take the assets and we subtract the liabilities:
Then finally we can check that liabilities and equity equal assets, like so:
And the result in cell E12 is of course $1650.
In finance we have Assets which are the use of the funds and on the other side of the equation we have Debt and Equity. Debt and Equity represent the source of funds:
If we look at the Source of funds we will see that there are two different items: Debt and Equity. What is the difference between the two?
The debt is a Fixed claim and is something that you must pay back to the lender at some point in the future + interest.
The Equity on the other hand is Residual claim which means that you as a company does not have to pay the holder back
If I go out and buy a stock of ABC Corp. in the stock market for $50, the company does not have to pay me back if the stock loses value.
If the company goes bankrupt and there isn’t enough money around to pay off the creditors I get nothing. Residual means “left over”.
Then we have dividends which are only paid out once there is something left over.
Why then would anybody like to do equity if it’s always residual?
It’s because of the upside. If you invest in a well run business with equity that is steadily growing then you can make a lot of money.
Interest expenses (cash out) are tax deductible. This means that when you are paying your taxes you will pay a little bit less if you have interest payments.
Let’s say that you are paying $2500 in interest then if you deduct the interest payments you will less than that (let’s say $2300).
On the other hand dividends (cash out) are not tax deductible which means that there is a slight advantage of using debt.
The creditors are also paid first during bankruptcy while if you have equity you will get whatever is left over.
We will now turn our attention to debt:
The question of whether to use debt or equity to raise funds is called Capital structure.
The term Financial leverage is used when the firm has debt. If you are using debt wisely you can reap the benefits of having your debt tax deductible and put the capital to productive use.
The more debt you have, the higher your leverage.
Leverage can magnify both gains and losses.
This will be the last topic that we will cover about the Balance sheet:
The Market value is the amount that you would get if you sold your equity stake.
For financial assets like stocks and debt you can go out and see what the value is every day.
But for a lot of equity this is not really possible so we need to estimate the market value.
Otherwise you do not know for sure until you sell your asset.
For fixed assets like machines and trucks finding a market value becomes much more difficult.
That is why accountants have invented the Book Value.
When I buy the business outright, the machines, the buildings and the inventory, that receipt is telling me what it is and will be the sum that I’m going to record.
That is also called the Historical cost principle and it is required by the Generally Accepted Accounting Principles (GAAP).
Then the Book value of the company often does not take into account the company’s most valuable assets such as:
These are all intangible assets, but it can be tangible assets also where the value of the assets can change radically from the price that you paid.
The Market value of an asset is almost always different from the Book value.
The goal of the financial management is to maximize the market value of the stock. At least in theory this is a good thing.
That means that the financial manager is more interested in the market value than he or she is of the book value.
We are given these numbers so we don’t have to research them:
Now we will calculate the Book value of the assets and we begin by adding cell B5 to the Book value in cell B16:
We then add the Book value of the Fixed assets to cell B17:
Then we do the same thing for the Market value. We begin by adding the Net working capital to cell C16:
We then continue the Market value of the Fixed assets (cell B4):
Finally we highlight cells B18 and C18 and use the keyboard shortcut Alt + =.
What that does is that it calculates an auto sum of the numbers above it:
We can then see that we have different numbers for Book and Market Value.
Finally we do the same thing for liabilities.
First we assume that the Book and Market value for the Long-term debt is the same:
So what is then Shareholders’ equity?
Remember the fundamental accounting equation in Figure 16:
Assets = Debt + Equity
That means if we fill in Total assets from cells B19 and C19 into B27 and C27:
we can then calculate Shareholders’ equity by subtraction:
Then we do the same thing for the Market value in cell C26.
The final result is like this:
In this section we will talk about the Income statement.
The Income statement is different from the Balance sheet in that it shows revenues, expenses and net income for the whole period.
On the other hand, what the Balance sheet showed us was valid just for a particular day.
The first thing that we are going to look at is the Revenue:
Total Revenue is the accounting term used for the Total sales of the business during the period.
Then we have Net sales which is the Amount earned by the business from delivering products or services.
You get this from taking the Total revenue and then subtracting any expenses.
Another thing that is important to recognize is that the company cannot record revenue before the product is delivered to the customer.
In accounting that is called accrual accounting.
The definition of accrual accounting is this:
As you can see there is both an Expense and Revenue meaning of the word.
If the business receives a bill and it isn’t due until 30 days later, they have to record the expense at the earlier date.
This is then an example of a hypothetical Income statement:
As you can see the statement is valid for the whole period ending on December 31, 2016.
For publicly traded stocks the reporting periods are either annual or by quarter.
In Figure 31 you will find a made up Income statement:
An Income statement is profit or loss for the whole period ( in this case the period is a whole year.)
We have our Total revenue and Cost of goods sold.
If you sell a widget for $100 and you paid $50 for it, you will record $100 as revenue and $50 for cost of goods sold.
If you look in cell C6 you will find an item called Depreciation and this is where accrual accounting comes in.
This is where the cash may be spent at at a different period from where it is received. We will look into when to book an expense like that.
It could come as cash, or it could come later as accounts receivables as we saw in the balance sheet.
Then we have Earnings before interest and tax which we get by subtracting Cost of goods sold and Depreciation from the Total revenue.
We calculate this by adding a formula. We first take Total revenue in cell C4 and subtract the sum between the Cost of goods sold in cell C5 and Depreciation in cell C6:
The result in cell C7 is then of course $1,928,000. We then do the same thing when we calculate the Taxable income by subtracting Interest paid (C8) from Earnings before interest and tax (C7):
The result in cell C9 is of course $1,856,000. Finally we are doing the same thing when we are calculating the Net income in cell C11 by subtracting taxes in cell C10 from Taxable income in cell C10:
The final Net income in cell C11 is then $1,536,00. The Net income (or the Earnings) can go in one of two places. Because technically they belong to the shareholders they can either be paid out in dividends or they can be plowed back into the business to buy more assets.
Generally if the company keeps a lot of retained earnings, it’s because they have good ideas of to make the company grow.
If we go back to the Balance sheet (Figure 8) and take a look at the item that is called Retained earnings, we now understand where that item comes from.
So in order to calculate how much money ABC Corp is keeping to plow back into the company we need to take the Dividend (cell C13) and subtract from the Net income (cell C11):
We will also consider the total number of shares outstanding. This means that at this particular date, the 31 December 2016, there were 210,000,000 shares outstanding.
Then we can calculate Earnings per share by dividing Net income (cell C11) x 1000 (because our numbers are divided by 1000 to begin with) by Shares outstanding (cell C15).
The formula looks like this:
The result in cell C16 will then be $7.31.
After that we continue with Dividend per share where we divide the Total dividend paid out in cell C13 (x 1000) with the total number of shares outstanding (cell C15):
The result in cell C17 will then be $0.31 which means that in this case the company keeps a lot of the earnings.
Then we come into the subject of depreciation:
In the following example we are using trucks for FedEx for $10 million with a Salvage value of 500,000 and an estimated time in use of 7 years:
The salvage value is what you would get out of your investment in a fire sale:
What this means is that if the cash goes out the first year, but that the Depreciation event is accounted for every year.
That means that there is no cash associated with it because it all went out the first year.
To give you an example of what I mean we first need to discuss the Matching principle:
This is part of the concept of accrual accounting that we discussed earlier in this chapter. What it means is basically that we need to add revenue and expenses in the right period so that they finally add up.
If we then look at Figure 39 again we see that we have a linear depreciation for our purchase of the assets over 7 years. What that means is that we assume that the trucks are going to last for 7 years.
But if we have the trucks they are going to generate revenue during that whole period and this we have to account for.
We do thisby matching the revenue that we are going to get from the trucks with the depreciation.
If we put this information into Excel it will look like this:
This is then the proper way of accounting for depreciation.
Another example of depreciation comes when we calculate Net capital spending or NCS:
What we are going to do is to calculate a Net cash flow from our accounting numbers.
The first thing that we need to look at is the begin number. The begin number we find in the Balance sheet item of Net fixed assets of the 31 December 2016 (cell B8).
Then we need to find the end number which is the Net fixed assets on the 31 December 2017 (cell B9).
That means that we have more cash at the end of the period than in the beginning (which is a good thing).
Then we need to look at the depreciation and because these items have already taken into account the depreciation we need to add it back.
The calculation therefore becomes B9 – B8 + B10. In Excel it looks like this:
The result in cell B12 is then of course $265,000.
We previously discussed the concept of accrual accounting.
There is a fundamental problem with it and that is that it doesn’t consider cash flow.
That is what financial managers are interested in, cash.
We therefore have to take the financial numbers of the balance sheet and the income statement and convert them into cash:
On the balance sheet accrual accounting is for instance affecting Net fixed assets. Similarly, on the Income statement, Sales are recorded when they are earned and expenses are recorded when they are paid out:
The next figure is again the fundamental accounting equation:
In finance we think of the equation like this:
When FedEx buys trucks or Coca-Cola buys buildings they are acquiring assets which in other words is use of cash or funds. The reason why they buy these assets is because they think that they are going to make a profit from them.
Where are we then going to get the cash from? The cash is coming from either Debt or Equity which are the source of funds.
This equation, where we have Use of cash and Source of cash, will be our starting point when we calculate cash flow.
So the first question to answer is “What is cash flow?”
In finance people care about cash in and cash out.
Cash flow is not the same thing as Net earnings.
We will therefore have to derive cash flow information from the Balance sheet and the Income statement.
We will look at how cash is generated from utilizing assets and how it’s paid to those that finance the purchase.
What this means is that Cash flow from assets can either go to the Bondholders or the Stockholders.
In the next figure all the calculations we are going to do are summarized:
If we begin with the second box we see that it says Cash flow from assets and the way to calculate it is by taking the Operational cash flow and subtracting Net capital spending and Changes in net working capital.
In order to calculate the Operational cash flow we need to take the EBIT (Earnings Before Interest and Taxes) and add back the Depreciation minus Taxes.
To understand this we need to take another look at our Income statment (Figure 45). There we see that we have an item called EBIT and below that we have Interest. Where does the interest go? To the creditors. This means that EBIT should belong to the Operational cash flow.
In the end we need to subtract the Taxes from EBIT and add back the Depreciation, because it’s a non-cash item.
To calculate the Net capital spending we need to take the end value of the Net fixed assets then subtract the value of the Net fixed assets at the beginning of the period and finally add back the non-cash Depreciation on the Income statement. We do this because we’ve already taken this into account when we calculate the value of the assets.
Changes in Working capital is all change calculated by taking something at the end of the period minus the beginning. In this particular case we do it by taking the working capital for the end of the period minus working capital for the beginning. How do we calculate the working capital? We do it by subtracting current liabilities from current assets.
Then we have the Cash flow that go out to our creditors. The first thing that we do is that we identify the Interest paid and then we subtract the Net new borrowing. The Net new borrowing is always the change of the Long-term debt, calculated as the long-term debt at the end of the period minus the long-term debt at the beginning.
Of course the net new borrowing can be both positive or negative. If the company takes on more debt then the Net new borrowing is positive and we will say Interest paid minus the new debt that we’ve issued will be our Cash flow to creditors.
At last we have Cash flow to shareholders which is similar to Cash flow to creditors. We begin by taking the dividends paid and then subtracting the Net new equity that we’ve raised.
The way that we calculate the Net new equity is that we begin by looking at value of the common stock and paid-in surplus at the end of the period minus the common stock and paid-in surplus at the beginning of the period.
Then we have defined all the cash flow calculations that we are going to do.
We are then going to take on a comprehensive problem. We will call it Exercise 1. In Figure 49 we have a lot of information that we are going to use:
We have information about the corporation, the dates and the tax rates and for a number of accounts we have a begin of a period and an end of the same period.
What we are going to do is to calculate an income statement, a balance sheet and then a cash flow.
This is then the income statement that we are going to fill out:
The first thing that we notice in the exercise is that the income statement is for the year 2017. That means that we only need to take the values for 2017. In cell C28 we therefore type =C15, like so:
Next we take the Cost of goods sold for the year 2017 which we find in cell C16:
Then the Depreciation for the year 2017 is found in cell C17:
Then we want to calculate the earnings before interest and tax and the way we do that is to take our Net sales and then subtract the Cost of goods sold and the Depreciation. In Excel it looks like this:
The result in cell C31 is then of course $930.
Then we want to find the interest which is given in cell C18:
Then we want to calculate the Taxable income. How do we do that?
We take our earnings before interest and tax (C31) minus the interest (C32), like so:
Then we are going to calculate the taxes. How much are we to pay in taxes?
To calculate that we first have to take the taxable income (C33) and multiply with the Tax rate (B5):
If we then hit enter we will get two decimals like this in cell C34:
What this then means is that we usually have to round to the nearest dollar (but in this case we don’t have to). So how do we do that?
In the same way that we can use the sum function for summing or the average function for calculating averages, there is a round function that we can use. It is used like this:
What do we do in Figure 59? We are rounding to the nearest dollar.
Finally to calculate the Net income we take the taxable income in cell C33 minus the taxes in cell C34, like so:
Then we have dividends which is given in cell C19:
Now the dividends can go in either of two ways. Either it goes out of the company to the shareholders or its kept within.
If it’s kept within the company, the dividends are to be used for purchase of new productive assets. Thus they are added to the retained earnings or subtracted from the net income, like so:
We then want to build our balance sheet.
First, we look at the current assets for 2016:
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In order to be a successful investor, you shouldn’t compare yourself to others.
It is difficult being an investor. Sometimes the price of your stocks rise for no apparent reason and sometimes they fall seemingly without any cause.
Then it is easy to either buy or sell just to make a few more dollars short-term, but that is a not how you should think about the problem.
The correct way is to make as few investment decisions as possible. Warren Buffet has famously said that “you would be better off if you limited yourself to, let’s say, 20 investment decisions in your lifetime”.
If the trading was limited, you would have to justify to yourself why and at what price you want to execute this particular trade.
Hopefully you would then skip a few of the bad deals that you are bound to do in affect.
That inevitably means that you will miss out on some opportunities.
But that is not a bad thing – it’s a good thing.
When you are seeing a stock rise, and you’ve carefully looked at the financials of that particular stock, it’s very satisfying finally being proven right.
Now you may be thinking “That sounds all very good, but I don’t want to keep my stock if it goes to zero.”
Again, that is not the way you want to think about your investments.
If the value of your stocks are falling it means that they have become cheaper and you can buy more.
Depending on the quality of your investment decisions, the dividend that you are receiving should be safe if you’ve bought good stocks.
That means that you will not miss out on the compound interest that you will earn by simply keeping your stock.
If you in any way are concerned about the compound interest please keep your stock.
In today’s post we have been looking at the many pitfalls when it comes to comparing your portfolio to others.