Free Cash Flow (FCF) is one of the most important metrics used to judge the value of a company. An example of the difference between using Earnings Per Share (EPS) and FCF with Google stock (GOOG)...
Any investor or trader in today's market is familiar with Google, the search engine titan whose stock has rocketed from a $90 IPO price to over $500 in a little more than two years and has continually confounded analysts attempting to establish a valuation target. It is perhaps one of the most controversial stocks on Wall Street today, because nobody seems to understand what the company is doing, yet the stock continues to move higher. Google latest quarterly earnings handily beat estimates, but the stock has been flat-to-down since, with investors apparently disappointed that Google didn't beat estimates by an even greater margin (there is also the recently repeated formula of tech stocks rallying into the earnings announcement and then selling off after, regardless). Considering that Google grew earnings year-over-year (YoY) at a greater than 100% clip, one has to wonder exactly what kind of expectations investors have for the stock - if triple digit earnings growth results in topping analyst estimates by 10% with no upward move in the stock, what will it take to move GOOG higher? For starters, free cash flow (FCF) growth proportional, or even in the same league as EPS growth, would help.
For those of you who are new to fundamental analysis, here is a quick introduction into the differences between the accrual-basis accounting that gives the much touted "Earnings Per Share" figure which, in reality, means nothing to the company. At the end of the day, the cash a company makes from its operating activities is what matters, so an investor's focus should be on the Statement of Cash Flows, not the Income Statement. Although Generally Accepted Accounting Principles (GAAP) are by and large a boon to investors because they standardize the reporting of earnings and make comparisons easy, the system is by no means perfect. The typical EPS number likely includes the effects of millions or even billions of dollars the company made (or spent) for reasons that have no connection to its actual business. Also, interpretations of GAAP allow companies to hide billions in obligations off the balance sheet and manipulate depreciation and amortization, stock based compensation (SBC) and stock options tax benefits to make the earnings picture far better than it is in reality. Proper attention to the Statement of Cash Flows and the right adjustments can cut through the accounting maze, as we will see with GOOG.
For the just released 4th Quarter data, Operating Income and Net Income obviously experienced great growth, which will inevitably allow analysts to continue applying a 40-50x earnings multiple and advising people to buy the stock. Such a high multiple gives an earnings yield of 2-2.5%, which is less than the yield on a Treasury Bill, but the argument goes that Google is growing at XX% per year, so its completely fine to buy now because of how quickly that earnings yield will grow. The analyst community is correct that the earnings yield will improve, perhaps quickly and dramatically. What the analyst community doesn't say is that the FCF yield - the relationship between cash generated and the market value of the company - is less than half the earnings yield and is growing pitifully slowly relative to earnings. For specifics:
Google's GAAP Operating Income for 2006: $3.07 B
Google adds back $458 million in SBC as a "non-cash charge", but I believe it should be deducted as a legitimate operating cost. Normally in valuation models, I don’t allow companies to benefit from adding back depreciation expense, but here I’ll let that go and won't trifle with any other lines in the cash flow adjustments except tax benefits from SBC in prior years, which has no material impact on the current year but helps keep variables held constant for making comparisons.
Google's Operating Cash Flow for 2006, according to Jelly Roll Capital Accounting: $3.12 B
Google's Capital Expenditures (CAPEX) for 2006: $1.92 B
Google's True FCF for 2006, per Jelly Roll Capital: $1.22 B
Google's True FCF for 2005, per Jelly Roll Capital: $987 Million
This calculation shows how Google's True FCF - that is, cash actually generated through its operations - grew at 23% in 2006. While certainly not a bad growth rate, it pales in comparison to Google's EPS growth rate near 100%. Further, on an Enterprise Value (Market Capitalization-Cash and Equivalents+Debt)/FCF basis, GOOG has a score over 100, which in my opinion represents an extreme overvaluation - there really is no margin of safety buying at such levels. Google stock is not a value investor's friend, and although GOOG bulls will continue touting the great growth rate and lowering earnings multiple, I'll continue looking at what matters - the cash flow - and seeking out companies that generate plenty of it on a consistent basis.
