CASH TRUTHS THAT AREN'T
Professional and Serious Investors use Cash Flow Analysis ... FALSE
Here are some quotes from the 2007 Level2 Vol2 Curriculum of the CFA (Chartered Financial Analysts) pages 193-222.
- Any shareholders who believe the value of a share of stock is a function of EBITDA are misleading themselves.
- While analysts, investors and creditors might be led to believe that operating cash flow and free cash flow are somehow above the creative accounting fray, that belief is unfounded.
- Even operations cash flow supported by profitable operations may not be sustainable.
- It must be stresses that operating cash flow is only the starting point.
It is hardest to argue for any use of cash flow in valuations. Beyond the issue of how to determine the particular 'flow' that is appropriate, there is the conceptual problem that value is determined by your anticipated economic gain. Cash flow makes no attempt to measure economic gain.
It is much easier to support the use of cash flow in determining future growth rates. For example, while a manufacturer's depreciation may make earnings weak, the cash value of the depreciation may be reinvested to MORE THAN fund replacement assets when the time comes. No one questions the use of cash flows in the evaluation of a firm's liquidity. In 2008-09 when bond markets and bank lending dried up completely, even very large, very profitable companies were suddenly at risk.
Cash Flow Is A Better Measure Than
Accounting Income Because It Cannot Be Manipulated ... FALSE
The 'cash flow' being referred to here is 'cash from operations'.
The complete statement of cash flow includes three types;
operations, investing and financing. Any good bookkeeper can tell you
how to move cash flows from the 'operating' to the 'investing' or
'financing' sections. Here is a list of ways to increase the
'operating' cash flow.
||Sell the receivables to a factor for
||Don't pay your suppliers for an
additional few weeks at period end.
||Management can create a separate (but
unrelated) company to do the sales job. The book of business is then purchased as an investment.
||Pay compensation with stock options.
||Prepay a maintenance contract with the company selling you the asset so it is included in the purchase price.
|Oil Exploration costs
||Replace reserves by buying another
Choose to use 'full-cost' accounting policy instead of 'successful efforts'.
||Wait for the product to be proven by a
start-up lab. Then buy the lab.
||Pay in shares of a new issue.
||Issue convertible debt where the
conversion rate changes with the unpaid interest.
||Pay the one-time penalty for prematurely calling high interest debt and reissue lower interest debt.|
|| Choose 'available for sale' accounting policy when purchase and 'trading security' policy when sell.
||Buy an existing business with the wanted working capital.
||Buy shelf companies with
TaxLossCarryForward's. Or gussy up the purchase by buying a lab or
O&G explore co. with the same TLCF.
||Redefine cash to exclude bank overdrafts.
When companies know they will be judged by 'operating cash flow'
they will, quite predictable, do all the above. None of it is
necessarily a good 'business' decision. You get what you ask for.
It is not only management manipulation and operational choices that change reported cash flows. The underlying financial reporting rules change all calculations - even cash flows. The change to International Accounting Standards (IFRS) in 2011 provides perfect proofs that measured cash is NOT a hard and fast reality. Here are comparative reports from Brookfield Properties Corporation - the 2009 Reconciliation from Net Income to Funds from Operations as originally published and as restated under IFRS. The reconciling items are not important. The reported cash flow differs by 17 percent.
|Brookfield Office Properties
Full year ended Dec 31 2009
Reconciliation of NI to Fund from Operations |
Amortization of debt
FX and restructuring
Fair value gains
|Funds from Operations||648||556|
That's A Non-Cash Expense: It Doesn't Count ... FALSE
Investors are told to simply ignore a wide range of expenses - depreciation, goodwill write-downs, changes to the translated value of foreign assets, gains/losses in financial futures contracts, restructuring charges, changes to the value of debt issued, etc, etc. It doesn't count when you are measuring ... what? Cash flows measure
...(duh) cash. What accountants try to measure, and what is used for economic and financial decisions is ... income, profit, growth in
value, how much better off the business is. Cash flows cannot measure economic values. They certainly do not do a better job than the accountant's measures.
Not only is there no correlation between cash and profit, the two are frequently inversely related.
Small business owners (with limited access to financing) understand
that sudden growth spurts, even while very profitable, almost always
cause HUGE cash problems when the business must finance a larger
inventory and accounts receivable.
On the flip side, is the failed company that no longer earns a
profit and is being closed down. The owner is liquidating assets, not
making any new investments, and generating PILES of cash.
There is no such thing as a 'non-cash' expense. Either there is a
barter transaction that should be considered two separate cash
transactions, or there is a timing difference between the cash
transaction and the reporting period when the accountant's value hits the Income Statement. Ask yourself whether you incur
your Christmas expenses in December (when you make the purchases) ...
or in January (when you pay the credit card bill). The economic reality is better reflected by the accountant's accrual.
The flip side of a non-cash expense is the non-cash revenue.
Ask yourself whether you earn interest every year over the 20 years of
the strip bond you own ... or earn income only in the last year when
it matures. The economic reality is better reflected by the accountant's accrual.
By their nature most investments are long-term projects. Different
projects, with cash flowing at different times, can be equally
profitable. Some have no cash inflows until the end (the strip bond),
some have cash inflows over their life (the oilfield), some never have
cash flows (the barter).
You cannot judge the investment by the cashflows in a
particular year. And you most certainly cannot judge an investment by
ignoring the outflows (in the 'investing' section) and counting only the
inflows (in the 'cash from operations' section).
The difference of opinion between those people who think Net Income
measures growth, and those who think cash flows measure growth, comes
down to an understanding of what cash flows are "returns of capital"
and what cash flows are "income" returns. See the definition and
discussion of 'Return Of Capital' at Wiki.
Real Estate Goes Up In Value, So Depreciation of Buildings Should Be Ignored ... FALSE
The argument goes - Depreciation should not be charged against real
estate, because property does not decline in value. Depreciation
is supposed to measure the wearing-out, or decline in value, or
obsolescence of an asset. Almost all declines in real estate values occur
because of insufficient repairs, maintenance, and upgrades. Unlike a
car that can only be preserved by not using it, 100 year old properties
are still usable.
That is a very good argument. There are counter arguments.
- Construction now is totally shoddy compared to the quality
work of the past. Visit a new industrial
park. Quality is shockingly bad and obvious to even the untrained eye. Our
buildings today will not be around in 100 years. In Vancouver the outer shells of most residential buildings constructed in the 1980's have had to be re-built 20 years later because of shoddy work.
- No depreciation is ever taken on land. While the value of land increases in value, the building may
be depreciating. The increase in land values masks the decrease in building value. To
determine whether the appreciation of property is due to the land or
the building, consider the resale price of city lots with tear-down
buildings. There is VERY little discount to the general market. The land is increasing in value, not the building.
- Governments allow taxpayers to deduct depreciation on
buildings. They are not in the habit of offering taxpayers freebees. Even the calculation of the Consumer Price Index CPI includes an allowance for about 1.5% depreciation of buildings (reference). The government has pretty smart economists on staff. There must be an economic reality to depreciation.
- Even if the building is in perfectly good shape, many are
torn down because of demographic shifts, zoning changes, fashion
changes, and a more affluent life style norm. Downtown hotels are
imploded. Suburban houses of 1200 square feet are leveled for new 2400
square feet construction. Obsolete strip malls are supplanted by
big-box centers. A study of non-residential buildings demolished in a US city found that almost 60% were for these reasons - not structual issues or fire or lack of maintenance.
- Repairs and replacements frequently do not take place. The outstanding work piles up until in total it is more efficient to demolish the building. Building codes change, wiring necessary for the computer age changes, desirable window sizes get larger, etc.
- People like 'new' things. They pay more for 'newness' regardless of little/no depreciation.
- The necessity for accounting depreciation depends on the owners treatment of costs for upgrades and maintenance. These cash flows vary widely over the life of a building (reference). If the cash flow costs for big-ticket items will be considered as capital costs, then depreciation over the preceding term is necessary. If those cash flows are expensed on the income statement as they are paid then Net Income will be unnecessarily lumpy. It is better to depreciate the building evenly over its life-span, and then treat asset replacements as capital.
When analyzing a stock by discounting cash flows no one ever models 20 years into the future. Yet many building assets have that kind of lifespan (reference). Discounted cash flow models must somehow make allowances for these guaranteed future cash needs. They must include non-cash allowances for depreciation.
In 2008, after five years of a real estate bull market, it is hard to think that a
building can lose value with age. Yet through the 1990's, there was no price appreciation. In that period,
many Vancouver owners faced bills for rain damage repairs equal to 50% of
their original purchase price. The current depreciation rate (about 4% of net cost) is probably too high by half, but some depreciation IS
In 2013, after the adoption of IFRS reporting rules in Canada, depreciation is no longer booked. Things have got a lot worse. The historical costs are no longer available. The split in value between land and buildings is no longer available. The Income Statement now includes another non-cash item to reflect management's idea of the change in market value of the real estate. A travesty that violates all accountant's underpinnings.
Depreciation Has No Economic Reality ... FALSE
Some history -- In the 1980's investors were in an uproar against the
accountant's calculation of depreciation. At the time inflation was
double digit, so expensing the historical cost of the asset UNDERSTATED
the reserves needed to replace the asset at an inflating price.
Academia came up with various possible solutions, but none really
In that context, it is humorous to hear analysts contend now, that the accountant's calculation OVERSTATES the cost of assets - they
frequently claim the true Maintenance CapX (capital expenditure) is only 10%-20% of the accountant's estimate of depreciation. While
accountants measure the cost of long-term assets in a logical and
quantifiable way, the analysts simply 'come up with a number' without
any calculation. To support their position they must argue that either
- deflation will lower the eventual replacement cost by 80-90%
- or, the expected life of the assets is 5-10 times longer than
the accountants think ...they are virtually indestructible!!! Question that. E.g. pipelines have extremely long lives. But in 2013 we now know that about a third of existing NA pipe has seam welds that are failing, and require very expensive remediation.
Management lies to investors when they claim that the replacement costs to maintain capital is much lower than depreciation. The proof shows up
when they lobby governments for faster tax write-offs of CapX.
The Income Statement depreciates assets at a slower rate than is allowed for
taxes. So when management claims that the larger tax allowance should be increased further, because it is lower than
the economic degradation of value, you have proof positive that the
Income Statement's depreciation UNDERSTATES reality. See this Globe&Mail article.
You can come to your own conclusions using the company analysis spreadsheet. If you feel depreciation is overstated, you must also believe (because each accounting entry has two sides.) that the net value sitting on the Balance Sheet should really be larger. Compare the growth in Revenues and Income with the growth of Property, Plant and Equipment. For most companies they will be pretty much in line with each other. Here is an examples: a growing medical supply company.
So what economic reality does Depreciation measure, and why? All assets (except land) wear out, or become obsolete. Assets must be replaced to sustain operations. When should their costs be recognized - at the time of purchase, over their productive life, or when they are replaced at the end of their life? Should mangement's decision on how to finance their purchase change the timing of cost recognition? Be clear that you are looking to measure an economic reality here. Depreciation can be consider from three points of view:
- Historical cost basis
- Forward looking basis
- Opportunity cost basis.
1. From the historical point of view, depreciation allocates the
original purchase price of an asset, to later years, when the revenues that result from its productive use are earned. At the time of purchase the cost is ignored, but it must eventually be recognized. You can argue that the asset's productive lifespan is a lot longer than the accountants think, but you cannot disagree that the productive life DOES end sometime.
Because 'a dollar now is worth more than a dollar later', the
allocation of ONLY the cost over the asset's life means that depreciation understates the economic cost (from this POV).
2. On a forward looking basis, depreciation represents the amount of
cash, from today's profits, that must be retained to eventually finance the replacement asset. Because that retained cash will be reinvested in the interim, it can pay the inflated value of the replacement asset.
Many companies can earn a rate-of-return on that cash that is far greater than the replacement asset's rate of inflation. From this POV, depreciation overstates the asset's economic cost. It is this reality that justifies the use of cashflow, instead of Net Income, in stock valuation and analysis. When a company's Net Income includes a large allowance for Depreciation, the cash available to fund growth is a lot larger than Net Income. Faster growth should justify a larger P/E multiple.
No one questions that higher cashflow companies can grow faster. Most all simple valuation metrics are adjusted for growth expectations. The question is ... Does the higher growth resulting from a larger cashflow justify the use of cashflow directly as a valuation metric?
3. On an opportunity cost basis, depreciation tries to equate the economic positions of companies who:
- buy and pay cash for the asset
- borrow money to buy the asset, repaying the principal and interest over its life
- lease the asset. Leases can be expensed as paid, or they can be put on the Balance Sheet (as an asset and also a debt) both of which are written off over the lease's life.
In all three cases:
- The purchase price of the asset is not 'expensed' at the time of purchase.
- Whether the purchase replaces existing worn out equipment, or expands productive capacity is irrelevant.
- The total cost of the asset flows through the Income Statement at some point.
- At the end of the asset's life, the company has no asset on its books and no lease debt.
- The cost of the asset is recognized as it is use; either as depreciation, or as lease payments.
Conclusion - Depreciation is a valid measure of the economic cost of a long-life asset. It involves estimation and an arbitrary allocation over time, but is still far better than 'expensing' an arbitrary portion of the cash flows at the time of purchase.
Free Cash Flow (FCF) Allows For Maintenance CapX ... FALSE
The metric "Free Cash Flow" (FCF) has become the accepted measure of cash to value a stock. It's calculation starts with the Cash Flow From Operations (CFFO) - the top section of the Statement of Cash Flows.
The major problem with CFFO as a measure of economic gains/losses comes from its bottom section where changes to working capital are added/subtracted. By definition working capital assets will be realized within a year. These adjustments are temporary. They reverse in the previous/following year. If used for valuation the reversals would result in major re-valuation of the stock each year. These adjustments can be huge. E.g. consider the effect of a new warehouse on the level of inventory.
FCF would be a much better metric if it started, not from the CFFO total, rather from Cash Profits - the subtotal (often missing) half way down CFFO, after the adjustments for long-life assets, but before the adjustments for working capital assets.
From CFFO is deducted the cost of long-life assets purchased that are considered to be replacements of existing capacity, but not including growth assets. This replaces the depreciation that was reversed out in the calculation of CFFO. Management may publish this value, but it is never audited and should be considered very, very subjective. The second section of the Statement of Cash Flow usually includes two different line items for a) purchases of operating divisions (or companies) and b) purchases of individual assets. The websites using databases of financial reports usually subtract the line item for Purchases of Assets in the calculation of FCF. Supposedly, all individual assets only replace existing capacity, and puchases of businesses are always for growth. Garbage! That is a completely arbitrary distinction with no economic reality.
Does the Purchase of Assets line item better measure the cost of long-life assets than depreciation? Not by a long shot.
- Some industries regularly buy up existing companies just to maintain their 'inventory' (for computer software providers), or pipeline of drugs (for drug companies), or reserves of resources (for Oil and Gas, and Resource companies). These purchases are ignored by FCF, but their economic impact is little different from a widget seller replenishing his inventory with the most current model.
- The purchase of individual assets included in FCF will be lumpy. Unless the company is very large and diversified there will be years of no purchases and years of large purchases. An individual year's purchases is no reflection of all future year's purchases. Even using an average of (say) 5 years' purchases will not even out the cost of assets with 20 year's lifespan.
- Expansion can be accomplished by buying-out existing operations (or companies), or by building additional warehouses, advertizing, spending more on Research and Development, etc. One strategy is neither better or worse than the other. Yet when FCF is capitalized to value a stock it will penalize the DIY expansion and give the buy-out expansion a free ride. For no economic reason.
- The same problem affects the growth of Current Assets. When a company grows by buying-out existing operations, the current assets of those operations are included along with the long-term assets in the line item in the second section of the Statement of Cash Flow. So any increase is ignored by the FCF metric. But the DIY expansion will have the increase in current assets decreasing the CFFO used in the FCF metric.
- Long term leases of assets are a valid option to outright purchases. The economics of the transaction may reflects a purchase, with only the overlay gloss of a lease. Yet the FCF metric would miss these non-cash transactions. The different company choice of financing would result in widely different stock valuations. For no economic reason.
Sure there are problems with the accountants' Net Income measure. But there are more problems with any attempt to replace accrual accounting with arbitrary, and widely variable cash flows. By their nature, cash flows do not measure economic changes. It is economic changes you need for stock market decisions.