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    Value Based Management: The Corporate Response to the Shareholder Revolution

     
    1/22/2001
    The rise in investor activism over the past 20 years has put a lot of attention on cash flow. However, John D. Martin and J. William Petty have found that many managers have little interest or understanding of the important distinctions within cash flow measures. Believing that these distinctions are key to firm valuation for managers and investors alike, Martin and Petty give cash flow a close look in this excerpt from their new book, Value Based Management: The Corporate Response to the Shareholder Revolution.

    by John D. Martin and J. William Petty

    Value Based Management

    Most managers think a lot about cash flow. They forecast it, worry about it, discuss it with their bankers, and constantly search for ways to improve it. But the concept is not widely understood. Just ask someone to define cash flow, and you will get a wide variety of responses, ranging from the balance in the firm's checking account to some ill-defined cash amount provided by the firm's operations.

    The appropriate definition and measurement of a firm's cash flow is driven by the reason for computing the cash flow. That is, how we intend to use the calculation matters. As one choice, we could use the conventional accountant's format, called a cash flow statement. In this statement, the accountant explains what caused the reported change in a firm's cash balance from one balance sheet to the next. Such knowledge, while meaningful for some purposes, has little relevance in managing the firm to create shareholder value. Instead we interested in the investor's perspective as to why cash flows matter. While there is similarity in the computations, the difference in perspective between the accountant and the investor is not merely semantic. The investor wants to know relevant cash flow in order to determine firm value, which is exactly what we want to know as well.

    What is the cash flow that matters to the firm's investors? It is the cash that is free and available to provide a return on the investors' capital. Simply stated—after all, it is not a complex matter—free cash flow is the amount that is available for the firm's investors.

    In addition, free cash flows are one and the same regardless of whether we view them from the firm's or the investor's perspective. There is an important equality that must be understood if we are to grasp the significance of free cash flows within a valuation context:

    The cash flows that are generated through a firm's operations and investments in assets equal the cash flows paid to—and received by—the company's investors.

    That is,

    Firm's free cash flows = Financing or investors' cash flows

    Let's look more closely at measuring free cash flows, first from the firm's perspective and then from the investor's perspective.

    Calculating a Firm's Free Cash Flows

    A company's free cash flows are equal to its after-tax cash flows from operations less any incremental investments made in the firm's operating assets. Specifically, free cash flows are calculated as follows:

       operating income

    + depreciation and amortization

    = earnings before interest, taxes, depreciation and amortization (EBITDA)

    - cash tax payments

    = after-tax cash flows from operations

    - investment (increase) in net operating working capital, which is equal to current assets less non-interest-bearing current liabilities

    - investments in fixed assets (capital expenditures) and other long-term assets

    = free cash flow

    In the foregoing calculation, we add back depreciation because it does not involve a cash payment. Also, the cash tax payments are the actual taxes paid, not the amount accrued in the income statement. Notice, too, that only non-interest-bearing debt, such as accounts payable and accrued wages, are included in computing the increase in net working capital.(1)

    To illustrate how to compute free cash flows, consider Johnson & Johnson's 1999 operations, a year in which the company produced $1.78 billion in free cash flow. The makeup of J& J's free cash flow was as follows (billions of dollars):

    Operating income $5.391
    Depreciation 1.444
    Earnings before interest, taxes, depreciation
    and amortization (EBITDA)
    $6.835
    Cash taxes 1.877
    After-tax cash flows from operations $4.958
    Nonoperating income .024
    Investment in current assets $1.714
    Increase in non-interest-bearing current liabilities .108
    Investment in net working capital      $1.606
    Investment in fixed assets and other long-term assets      1.601
    Free cash flows $1.775

    Thus, in 1999, Johnson & Johnson generated $4.96 billion from operations plus $24 million from nonoperating activity. This amount, however, was reduced by incremental investment in net working capital of $1.6 billion invested in fixed assets and other long-term assets.

    What happened to the 1.78 billion in cash flow that Johnson & Johnson produced? Quite simply, this amount was "free" to be paid out to the firm's investors. Determining the amount of cash received by Johnson & Johnson's investors validate this fact.

    Calculating the Investors' Cash Flows

    We can compute the cash flows received by a firm's investors, i.e., the financing cash flows, as follows:

       interest payments to creditors

    + repayment of debt principal

    - additional debt issued

    + dividends paid to stockholders

    + share repurchases

    - additional stock issued

    = financing cash flow

    Thus, the financing cash flows are simply the net cash flows paid to the firm's investors, and if negative, the cash flows that are being invested in the firm by the investors. We already know that Johnson & Johnson had $1.78 billion in free cash flow in 1999. We should expect this amount to be equal to the cash flow received by the investors, which is confirmed as follows (billions of dollars):

    Interest paid to creditors $.197
    Reduction (repayment) in debt principal      .082
    Dividend payments 1.479
    Repurchase of stock .017
    Free cash flows $1.775

    As already suggested, the firm's free cash flows are always the same as the cash flows remitted to the firm's investors.

    To summarize, a company's free cash flow is equal to its cash flow from operations less any additional investments in working capital and long-term assets. Furthermore, a firm's free cash flow is equal to the amount distributed to its investors—thus, the name free cash flow.

    We find it interesting that when we present this equality to executives, some do not find it as intriguing and significant as we do. A few will say, "What's the big deal? All we would have to do is change the amount or form of what is being paid to investors and thereby change the free cash flow." While this is true, they fail to understand that the amount and makeup of a firm's free cash flow are not the result of "playing with the numbers." Instead, free cash flows are the consequence of management policies and practices that have implications for investors regarding the firm's value. We should recognize that a firm's free cash flows are the result of operating, investing, and financing decisions, not some ad hoc number that can be manipulated as we want.

    · · · ·

    Excerpted from Value Based Management: The Corporate Response to the Shareholder Revolution, HBS Press, 2000.

    (1) Non-interest-bearing current liabilities (NIBCLs) are part of the firm's operating cycle as it purchases inventory on credit, sells on credit, pays its accounts payable and accruals, and eventually collects from its customers. Interest-bearing debt, on the other hand, is a source of financing provided by return-seeking investors, and as such is not part of the firm's recurring operating cycle.

    [ Order this book ]

    Free Cash Flows: That's What Matters

    Even the infamous Motley Fool, a Web-based investment advisory service, recognizes that to some investors free cash flows drive a firm's value. According to The Motley Fool

    Dell Computer continues to roll on, gaining $8-5/8 to $118-3/16 this morning after reporting second-quarter results that again blew the rest of the industry off the face of the earth. The direct seller of computer systems reported its eighteenth consecutive quarter of record revenues and fourteenth consecutive quarter of 40 percent or more year-over-year growth in revenues. The company ended the quarter as the industry's leader in profitability, revenue, and unit growth, and in asset management. Indeed, the company's focus on economic returns on capital rather than EPS growth are part of the reason why the Dell model, conceptually and practically, continues to lead the industry and create value for shareholders.

    "People can point to a Dell as an example of a market mania or people can point to things that people say about Dell as another sign of a market top. I simply think Dell demonstrates the limitations of looking at accounting-based returns rather than looking at the economic returns," said Randy Befumo of Legg Mason Fund Adviser in Baltimore. "GAAP accounting for earnings does not capture the $1.5 billion in cash that Dell has generated from its negative working capital float over the past eleven quarters." Once again, free cash flow (earnings before depreciation minus capital investment and working capital investment) ran in excess of reported earnings at Dell—the eleventh quarter in a row for that to take place. At its highest point, free cash flow was running at 323 percent of reported earnings. [As a result,] the company generated a 217 percent return on invested capital and $641 million in cash from operations.

    — Dale Wettlaufer
    The Motley Fool
    August 19, 1998

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