How Stock Fundamentals are Derived from Company Financials Part 3: Cash Flow Statement

File folderThis is the third and final installment of my series which looks at how company fundamentals are derived from the financial statements they’re based on. Previously we looked at the balance sheet and income statement, and in this article we’ll explore the often misunderstood cash flow statement. The cash flow statement ties the other financial statements together, in that it examines how the balance sheet changes, based on income and cash flow into or out of the company, and is a good measure of the company’s liquidity.

It’s much easier to understand if we use an actual example to go by, so let’s use Coca Cola’s (KO) latest annual report (2011). The report can be downloaded here.  We’re interested in the cash flow statement, which can be found on page 80 of the report. (click to enlarge)

KO_CF

We’ll be using GuruFocus’ numbers as a comparison to the ones we derive ourselves. A link to Coke’s fundamental data on GuruFocus can be found here.

Free Cash Flow (FCF)

Free cash flow is a very important metric that represents the amount of money a company has to pursue means of increasing shareholder value, such as developing new products, making acquisitions, paying dividends, and debt reduction. It is defined as the remaining cash available after expending funds to maintain or expand its asset base, explicitly shown in the following equation:

EBIT(1-Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditure

The first three terms in the above equation equate to the Cash Flow from Operations line on the cash flow statement. This simplifies the above equation to the following:

FCF = Cash Flow from Operations – Capital Expenditure

Both of these terms are found on the cash flow statement. Coca-Cola’s cash flow from operations was $9,474 million in 2011, found in line item net cash provided by operating activities. Capital expenditure can be found in the investing activities section of the cash flow statement, under line item Purchases of property, plant, and equipment. Coke’s capex in 2011 was $2,920 million.

We now calculate FCF by subtraction: 9,474 – 2,920 = 6,554. Therefore, Coke had a free cash flow of $6,554 million in 2011. This is confirmed by GuruFocus as follows (click to enlarge):

KO_FCF

Free cash flow is used in many popular valuation methods, including the Discounted Cash Flow (DCF) method. We used Coke’s operating cash flow above as part of the calculation of free cash flow, but operating cash flow on its own is a useful number. By comparing operating cash flow to net income, the quality of the company’s earnings can be qualitatively stated. Company’s which have an operating cash flow consistently greater than net income are said to have high quality earnings.

Price to Free Cash Flow

With FCF in hand, we can now calculate two other metrics, FCF per share, and the Price to Free Cash Flow ratio. We need two other pieces of information to do this: the current price of KO, and the number of common shares outstanding. As of today, Coke was trading at a price of $37.64 per share, and according to the income statement, there are 2,323 million shares outstanding (diluted).

First we calculate FCF per share:

FCFPS = FCF / # shares

Based on a FCF of $6,554 and 2,323 shares outstanding, FCFPS equates to $2.82 / share. We can now determine the P/FCF ratio as follows:

P/FCF = Price / FCFPS

Plugging in the price of $37.64 and the FCFPS of $2.82 calculated above, the P/FCF ratio for Coke is currently 13.3. This ratio can be used as a comparison between companies as a relative gauge of how expensive/cheap the company is. A higher P/FCF ratio indicates that you are paying more for a given free cash flow.

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4 thoughts on “How Stock Fundamentals are Derived from Company Financials Part 3: Cash Flow Statement

  1. If I could I would hop around like a leprachaun chanting “Free Cash Flow! Free Cash Flow!” I love it! As you know it is very hard to forge free cash flow and it is the first indicator I look for when evaluating a company. It has helped me save so much time over the years. There was no need for me to continue evaluating a company if there free cash flow was weak or if their share price was at a crazy multiple of FCF.

  2. […] Part III: How Stock Fundamentals are Derived from Company Financials: Cash Flow Statement […]

  3. CI says:

    Thanks for writing this article!

    The cashflow statement is particularly important for dividend investors such as myself, but is useful for other strategies as well. Tobacco companies tend to shine in this area; utilities not so much.

  4. Brett Wilson says:

    Great analysis. Free cash flow is probably one of the most important metrics out there. It is an easy way to quickly analyze a company.

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