Hi GFG,
Hyperion and Tree here.
(04-01-2015, 12:49 PM)GFG Wrote: [ -> ]For a simplified way to calculate FCF, I usually just take the "Net cash used in/from operating activities" - capex (eg purchase of PPE etc)
Can some pro advise if this is fairly accurate?
Bruce Greenwald would recommend you to differentiate between maintenance capital expenditure and growth capital expenditure to obtain an estimate of the "sustainable" free cash flow generated by the business. So Free Cash Flow for shareholders = Net Cash Used In/From Operating Activities - "Maintenance" Capital Expenditure - debt repayment - cash interest expense - preference share compulsory dividends - cash redemption of preference share.
For example, let's say Hyperion owns a retail business called Hyper Retail Shops, and he spends SGD 1mil to open 10 shops last year, it would appear under purchase of PPE. But this amount is to be excluded in estimating sustainable free cash flow because Hyperion is not expected to keep opening 10 shops for next 20 years every year and thus SGD 1mil is only during periods of growth. This amount SGD 1mil is referred to as growth capital expenditure.
A common problem is that companies do not report separately the amount of capital expenditure spend to grow the business, so sometimes you need to read the Chairman's discussion on the year's business performance to get the amount of capital spent to grow the business or read the announcement or read the news. For example, let's say Hyperion, the Chairman of Hyper Retail Shops says, I spend SGD1mil to open 10 new retail shops this year in the management discussion section. You can thus exclude SGD1mil from capital expenditure and thus your free cash flow actually increases. Good news is recent changes in International Financial Reporting Standards is encouraging companies to separate maintenance and growth capital expenditure for analyst to estimate free cash flow better.
Other methods include assuming that current year depreciation of PPE would be equal to the maintenance capital expenditure and thus use depreciation in the free cash flow calculations. However, further adjustments to account for inflation, investment cycle and accounting policy for depreciation is required. For example, let's say Hyperion obtained a concession to run a port business in Singapore called Hyper Monopoly Port for 20 years, and every year he says he depreciate the property by SGD2mil based on historical cost of PPE. He renovated the port just recently and has 20 years more to run it. Currently his maintenance capital expenditure is SGD1mil. Hyperion would recommend you start with SGD1mil every year for maintenance capital expenditure and apply the construction material or construction cost inflation index(if such a statistic is available) like say at 8% every year and project the capital expenditure to increase 8% until the final 20th year. This is because in the beginning after an investing cycle(renovation), usually capital expenditure is less than depreciation. Think about it this way, you just bought a computer, so each year you just change the hard disk drive or some spoiled part, so the expenditure its less than the depreciation. Eventually, due to inflation, capital expenditure will increase such that in the final year(year 20) you actually spend SGD4.66mil at 8% inflation which is significantly more than the 20 year historical cost of depreciation at SGD2mil!
This is assuming you trust Hyperion depreciates his PPE according to the useful life of the PPE. Let's say cheeky Tree wants to mess with you. So Tree depreciate the PPE on the assumption that it will only last 10 years, instead of 20 years. This means the depreciation would increase significantly and would not be a good estimate for maintenance capital expenditure. Fortunately, Hyperion can figure out Tree's little trick. Hyperion recommends you read the section on PPE depreciation policy, PPE remaining life left, and the note to PPE because you can find clues that Tree is making fun of you. For example, you will see that PPE useful life under the depreciation would only be 10 years and when compared to another port business is significantly short. Further, auditors might make Tree disclose in the note to PPE that he has SGD20mil of PPE that has been depreciated but still in use. This would raise the red flag that the PPE depreciation policy might be aggressive.
One real life example is ThaiBev. Looking at the PPE note, Tree told Hyperion that ThaiBev disclosed in two short lines that it is still using PPE that has been fully depreciated. This means, it would be difficult to estimate ThaiBev's actual maintenance capital expenditure based on just historical depreciation.
(04-01-2015, 12:49 PM)GFG Wrote: [ -> ]I figured the "net cash used in/from operating activities" already includes the EBIT and depreciation etc.
Am I missing out anything leading to inaccuracies?
Hyperion recommends you to go through line item by line item in the P&L and compare to the section Cash Flow from Operating Activities to ensure that all non-cash or non-operating cash has been excluded. This is because different business have different specific line items that might mess up your calculations.
Tree recommends you consider pension liabilities that need to be settled in cash in future which sometimes do not appear on balance sheet or costs of share-based compensation after you finish discounting your cash flow. This is particularly difficult especially for companies like OCBC which have a strong share-based compensation plan. As to how to adjust for share-based compensations, it is for another day when Tree feels like it. Hyperion can't help you on this.
(04-01-2015, 12:49 PM)GFG Wrote: [ -> ]Also, I found that most companies that are listed in SGX have fairly unstable FCF varying from year to year. Even if they are growing, the FCF can jump and fall drastically when comparing annual figures, so I generally just take a 5 year average and compute a minimal growth rate of about 5-10% (if there's some sign of growth)
The discount factor I take is usually about 2-3% above the long term bond yields. (so I take it as approximately 6% now)
Any pros got any comments? Thanks
Which company you refer to which have unstable FCF? Hyperion would like to know and he may be able to make Tree check out those companies for you.
If FCF jumps, you would like to trace whether it is due to revenue or cost. Either way it is not a good sign because it means that there is no certainty in the revenue or cost and thus FCF cannot be reliably predicted. Averaging does not help. In this case, Hyperion suggests you use net tangible assets which excludes goodwill or intangibles to value the company.
Hyperion notes that the discount rate becomes very aggressive once growth of 5% is used. A discount rate of 6%, and growth rate of 5% actually means you discounting at 1%, which is like the risk free rate. As of 22 December, the Edge reports that the 5 year Singapore Government Securities(SGS) yields are 1.5% which means you are discounting even lower than the SGS assuming the business can last 5 years. This is why it is tricky to value how much growth is worth.
Hyperion likes to highlight that unlike other countries, the Singapore Government Securities market is small and a bit more illiquid and thus might not be able to reflect the true risks free rate in Singapore. You may have to use an average of various triple A rated corporate bonds of blue chip companies like Singtel etc.
Tree said according to the famous journalist Teh Hooi Ling's article in Business Times on 20 Nov 2010, the average spread between equity returns versus 5 year SGS rates is 5.2% since 1998. Equity returns exclude dividends. This means Equity Returns - 5yr SGS = 5.2% on average. So you may consider using 5.2% above 5yr SGS bond yields which is currently around the 6% figure you had used.
Tree also said that you might want to be cautious when it comes to a company with many different business segments. Different business have different cash flows and different risks and thus doing free cash flow analysis on an overall basis would get you into trouble because you may be discounting a very risky cash flow at too low a discount rate.
Since this is a long reply, Tree likes to give you a potato.