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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.


CHAPTER 1: Investing 101.


Free Cash Flow.

Risk and Return.

The Return Multiple.

Return and Price.



Debt versus Equity.

Private Company versus Public Company.

CHAPTER 2: The Accounting Fog Machine.

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

GAAP: Accrual Abuse.

GAAP: Errors Bred by Complexity.


GAAP EPS: An Incomplete Definition of Financial Performance.

GAAP EPS: Investing in an Economic Vacuum.

EBITDA is Not a Cash Flow Metric.

The GAAP Cash Flow Statement.

Beware the Balance Sheet.


Fixed Assets and Depreciation.

Leverage and Debt Service.

Whose Return on Equity?

The Notes.

When Do Accruals Meet Cash Flows?

What is to be Done?

CHAPTER 3: Free Cash Flow.

Reconciliation of Net Income and Free Cash Flow.

Free Cash Flow versus Net Income.

A Universal Definition?

Academic Research and the Discounted Cash Flow Model.

Barron?s Rankings.

Buy-Side Users.

Private Equity Firms.

Warren Who?

A Vast Media Conspiracy?

FASB Staff Findings.

FAS 95: A Cruel Rule.

EPS Misses: The Real Deal.

An Alternative to the Government Number.

CHAPTER 4: The Free Cash Flow Statement.

Building the Free Cash Flow Statement.

Four Key Questions.


Operating Cash Flow.

Ä Working Capital.


Capex: Magnitude and Risk.

Capex and Capital.

Capex Transfer.

Capex Visibility.

Capex and Investor Return.

Free Cash Flow.

Free Cash Flow Yield.

CHAPTER 5: Free Cash Flow Deployment.





Projecting Investor Return.

CHAPTER 6: The Free Cash Flow Worksheet.

Worksheet Features.

Entering Historical Data.

Adjustments to GAAP Cash Flow.

Operating Cash Flow.


From the Balance Sheet.

The Free Cash Flow Statement.

GAAP Data.


Per Share Data.

Incremental Data and Company?s Reinvestment Return.

Cash Sources and Deployments.






Projecting Free Cash Flow.

Projecting Cash Sources.

Projecting Acquisitions.

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

Projecting Investor Return from Dividends.

Projecting Δ in Share Value Due To Δ in Debt.

Projecting Δ in Share Value from Operations.

GAAP Data, Percentages, and Per Share Data.

Incremental Data and Company?s Reinvestment Return.

Investor Return Projection.

Return Multiple.

Adding Periods to the Worksheet.

Using the Worksheet.

CHAPTER 7: Six Companies.


Percentage Change in Revenues.

Operating Cash Flow Margin.

Capex as a Percentage of Revenues.

Free Cash Flow Margin.

Free Cash Flow Per Share.

The Government Number.

Net Nonworking Capital Items.


Panera Bread.


P. F. Chang?s Bistro.

Cheesecake Factory.


Three Musketeers without New Unit Capex.

Whose Return on Equity?

Sell-Side Analysts.

Total Returns.

Take Your Pick.

CHAPTER 8: The CEO and Investor Return.

The CEO?s Letter to Shareholders.

The Quarterly Earnings Conference Call.

The CEO?s Incentive Compensation.

CHAPTER 9: Finding Great Stocks.

The Nine Steps.

Diversification for Individual Investors.

Equity Mutual Funds.

Free Cash Flow and Bonds.

Free Cash Flow and the Financial Crisis of 2008.

APPENDIX A: Equations.

APPENDIX B: McDonald?s Income Statement.

APPENDIX C: McDonald?s Balance Sheet.

APPENDIX D: McDonald?s ROIIC and Weighting.

APPENDIX E: McDonald?s ROIIC Calculations.

APPENDIX F: Recommended Reading.



About the Author.

About the Website.


Six Restaurants
Free Cash Flow Worksheet