Posts In:

Free Cash Flow: Adjusting For Acquisitions, Capital Allocation And Corporate Character

Someone who reads my articles sent me this email:

…. I would appreciate your thoughts on three questions of mine:

When calculating the free cash flow of serial acquirers, should the acquisition costs be factored in?

What are your thoughts on using pre-tax earnings, FCF, etc., yields to evaluate the attractiveness of securities. Intuitively, post-tax is all that matters, but pre-tax numbers allow for a more straightforward comparison between equities and fixed-income securities.

Now for a more company-specific question. Sotheby’s (BID) is inherently a very good business, but management owns only a small sliver of equity and in the past has failed to act prudently in the use of the balance sheet (impairment charges show up on cash flow statement following downturn in art market). The language in the SEC filings since that point is encouraging… which brings me to my question. How can an investor evaluate if management has learned from past missteps? Or is it so time consuming that a more efficient use of time would be to move on to other ideas?

Thanks again,

 

Patrick

 

Great questions. I get similar questions a lot. Especially about how to treat cash flows used for acquisitions. Is it really free cash flow? Or is it basically just another form of capital expenditure?

 

And questions about management changing their stripes are very, very common. That’s a tough question. But since these two questions are connected, I’ll start with the acquisition issue first.

 

When calculating the free cash flow of serial acquirers, should the acquisition costs be factored in?

 

Yes. If the company really is a serial acquirer, acquisition costs should be considered equivalent to cap-ex. The issue of acquisitions is always one that can be considered part of cap-ex or not part of cap-ex. If spending on acquisitions is treated as if it is part of cap-ex, then your expectations for that company’s growth would be higher (because they would be growing through acquisitions). If it is not counted as part of cap-ex, then your expectations for that company’s growth should be lower (because you are not treating acquisition spending as a normal part of the company’s year-to-year progress).

 

Sometimes it may be easier to estimate growth before acquisitions.

 

For example, a company involved in a mundane business like running hair salons – like Regis (RGS), dentist offices – like Birner Dental (BDMS), grocery stores – like Village Supermarket (VLGEA), or garbage dumps – like Waste Management (WM), may be easy to estimate as essentially a no-growth business.

 

Sotheby’s would be harder. Because there is not a steady, year-in-year-out kind of demand for their products. And a growth company like Facebook would also be impossibly hard to evaluate this way. There is no normal industry wide rate of growth at those kinds of businesses. You simply have to evaluate them on a company-specific basis. You have to dig into their growth stories the way someone like Phil Fisher would.

 

But what about…

Read more