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Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks

Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks

George C. Christy

ISBN: 978-0-470-48498-2

Jan 2009

224 pages



The purpose of this book is to explain Free Cash Flow and how to use it to increase investor return. The author explains the differences between Free Cash Flow and GAAP earnings and lays out the disadvantages of GAAP EPS as well as the advantages of Free Cash Flow. After taking the reader step-by-step through the author's Free Cash Flow statement, the book illustrates with formulas how each of the four deployments of Free Cash Flow can enhance or diminish shareholder return. The book applies the conceptual building blocks of Free Cash Flow and investor return to an actual company: McDonald's. The reader is taken line-by-line through the author's investor return spreadsheet model: (1) three years of McDonald's historical financial statements are modeled; (2) a one-year projection of McDonald's Free Cash Flow and investor return is modeled. Five other restaurant companies are compared to McDonald's and each other using both Free Cash Flow and GAAP metrics.

Foreword xv

Preface xix

CHAPTER 1 Investing 101 1

Price 1

Free Cash Flow 2

Risk and Return 3

The Return Multiple 4

Return and Price 4

Debt 6

Equity 9

Debt versus Equity 11

Private Company versus Public Company 12

CHAPTER 2 The Accounting Fog Machine 15

GAAP: Competing Theories, Matters of Opinion,Political Compromises 16

GAAP: Accrual Abuse 17

GAAP: Errors Bred by Complexity 17

GAAP’S Gap 18

GAAP EPS: An Incomplete Definition of Financial Performance 18

GAAP EPS: Investing in an Economic Vacuum 18

EBITDA is Not a Cash Flow Metric 19

The GAAP Cash Flow Statement 19

Beware the Balance Sheet 20

Liquidity 21

Fixed Assets and Depreciation 21

Leverage and Debt Service 22

Whose Return on Equity? 22

The Notes 23

When Do Accruals Meet Cash Flows? 23

What is to be Done? 24

CHAPTER 3 Free Cash Flow 25

Reconciliation of Net Income and Free Cash Flow 25

Free Cash Flow versus Net Income 27

A Universal Definition? 28

Academic Research and the Discounted Cash Flow Model 29

Barron’s Rankings 30

Buy-Side Users 31

Private Equity Firms 31

Warren Who? 31

A Vast Media Conspiracy? 32

FASB Staff Findings 32

FAS 95: A Cruel Rule 33

EPS Misses: The Real Deal 33

An Alternative to the Government Number 34

CHAPTER 4 The Free Cash Flow Statement 35

Building the Free Cash Flow Statement 35

Four Key Questions 40

Revenues 41

Operating Cash Flow 43

Δ Working Capital 44

Capex 45

Capex: Magnitude and Risk 46

Capex and Capital 47

Capex Transfer 48

Capex Visibility 48

Capex and Investor Return 49

Free Cash Flow 49

Free Cash Flow Yield 50

CHAPTER 5 Free Cash Flow Deployment 53

Acquisitions 54

Buybacks 56

Dividends 59

Debt 60

Projecting Investor Return 61

CHAPTER 6 The Free Cash Flow Worksheet 65

Worksheet Features 66

Entering Historical Data 68

Adjustments to GAAP Cash Flow 68

Operating Cash Flow 71

Capex 71

From the Balance Sheet 72

The Free Cash Flow Statement 73

GAAP Data 74

Percentages 75

Per Share Data 76

Incremental Data and Company’s Reinvestment Return 77

Cash Sources and Deployments 78

Acquisitions 80

Buybacks 80

Dividends 81

Debt 82

Operations 82

Projecting Free Cash Flow 83

Projecting Cash Sources 86

Projecting Acquisitions 87

Projecting Δ in Share Value Due to Δ in the Number of Shares 88

Projecting Investor Return from Dividends 90

Projecting Δ in Share Value Due To Δ in Debt 91

Projecting Δ in Share Value from Operations 94

GAAP Data, Percentages, and Per Share Data 94

Incremental Data and Company’s Reinvestment Return 95

Investor Return Projection 96

Return Multiple 98

Adding Periods to the Worksheet 100

Using the Worksheet 100

CHAPTER 7 Six Companies 101

Revenues 102

Percentage Change in Revenues 102

Operating Cash Flow Margin 103

Capex as a Percentage of Revenues 105

Free Cash Flow Margin 106

Free Cash Flow Per Share 107

The Government Number 109

Net Nonworking Capital Items 109

McDonald’s 111

Panera Bread 113

Applebee’s 114

P. F. Chang’s Bistro 115

Cheesecake Factory 116

IHOP 118

Three Musketeers without New Unit Capex 121

Whose Return on Equity? 121

Sell-Side Analysts 124

Total Returns 125

Take Your Pick 125

CHAPTER 8 The CEO and Investor Return 129

The CEO’s Letter to Shareholders 129

The Quarterly Earnings Conference Call 135

The CEO’s Incentive Compensation 137

CHAPTER 9 Finding Great Stocks 145

The Nine Steps 145

Diversification for Individual Investors 150

Equity Mutual Funds 151

Free Cash Flow and Bonds 152

Free Cash Flow and the Financial Crisis of 2008 152

APPENDIX A Equations 153

APPENDIX B McDonald’s Income Statement 159

APPENDIX C McDonald’s Balance Sheet 162

APPENDIX D McDonald’s ROIIC and Weighting 164

APPENDIX E McDonald’s ROIIC Calculations 165

APPENDIX F Recommended Reading 168

Notes 171

Acknowledgments 174

About the Author 175

About the Website 176

Index 177

Six Restaurants
Free Cash Flow Worksheet