Calculating Free Cash Flow: Should You Include Changes in Working Capital?

A reader sent me this email:

Geoff,

I have just recently started to use discounted cash flow analysis with owners earnings. You have stated that changes in working capital should be included in owners earnings calculation. However, a lot of value investors on the web seem to think that changes in working capital should not be included…Up until now, I have excluded changes in working capital. But your articles have made me think that I should include it. If you don’t mind, please clarify this for me. I just want to use the right data for my discount cash flow analysis.

Geoff, if changes in working capital is included in owners earnings then would the owner’s earnings formula simply be: cash from operations – maintenance capex? I sure hope so, because having to exclude working capital is very confusing because not all financial sites list it the same way.

Also, what free financial site has the most accurate cash flow statements? I personally have been using MSN MoneyCentral, but I (am) starting (to notice) that sometimes their figures are different than the company’s 10K filing. Any suggestions?

Thanks,

Chad

Yes.

You should include changes in working capital. So, when I say free cash flow I simply mean “cash flow from operations” less “capital expenditures”. Some people talk about separating growth capital spending from maintenance capital spending (including Warren Buffett). They’re obviously smarter than I am or have access to financial statements I don’t. The statements prepared for outside investors – not management – don’t provide enough detail to separate growth capital spending from maintenance capital spending in more than 90% of the cases. Birner Dental Management Services (BDMS) is a rare exception.

Warren Buffett was explicit on the issue of including working capital in his 1986 letter to shareholders:

If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included…)

I don’t do discounted cash flow calculations. Charlie Munger says Warren Buffett doesn’t either.

A lot of people do discounted cash flow calculations. And a lot of people don’t wear seat belts.

Discounted cash flow calculations are the most misused tool in investment analysis. I think they’re insanely risky. But, again, most people disagree.

I read the statements at EDGAR. The figures I cite here are always taken from EDGAR and then adjusted as necessary by me.

You can use GuruFocus, Morningstar, or MSN Money for a first glance at the ten year numbers. None of them are accurate enough to replace EDGAR.

Obviously, some companies decrease working capital year after …

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GuruFocus Articles

From some of the emails I’ve gotten from readers the last few days, I realize there are some people coming to this blog who don’t know I write articles for GuruFocus.

No one’s forcing you to read them. But you should know you’re missing some stuff I write if you just read what appears on this blog.

You can always click on the “Read Articles” link in the right sidebar to see a full list of my articles.

Here are the most recent ones:

Warren Buffett: Mid-Continent Tab Card Company

Warren Buffett: Make the Past Your Crystal Ball

How Warren Buffett Thinks About Micro Cap Stocks

Warren Buffett: How to Make 50% a Year in Micro Cap Stocks

Talk to Geoff About GuruFocus Articles…

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Build Your Own Ben Graham Library

If you want to fully understand Ben Graham, you should own the following Ben Graham library:

In Print

1. Benjamin Graham on Investing (1917-1927) – $20.76

 

2. The Rediscovered Benjamin Graham (1932-1977) – $29.70

 

3. The Interpretation of Financial Statements (1937) – $17.84

 

4. Security Analysis (1940) – $34.71

 

5. Benjamin Graham: Building a Profession (1945-1977) – $20.82

 

6. The Intelligent Investor (1949) – $19.39

Out of Print

1. Benjamin Graham: The Memoirs of the Dean of Wall Street ($44.99 Used)

That’s a total cost of $143.22 to build a complete – for our purposes – Ben Graham library counting only books in print. And $188.21 if you include a used copy of the memoirs.

So you can buy a complete library of Ben Graham’s investment writing for about $200 at Amazon.

A couple ex-library copies of the memoirs have passed through my hands over the years, and they’re usually in good shape. Ben Graham’s memoirs appeal to such a niche audience, it’s likely no one actually read the library’s copy.

The memoirs only touch on investing in spots. But if you’re really into Ben Graham, you should get them. Buying these books is only worthwhile if you both have an appetite for Ben Graham’s stuff and you’re a voracious reader.

I read old books, papers, etc. It’s something I like doing. If you don’t like reading stuff that’s 60 to 90 years old, you probably aren’t going to like reading these books.

Some people can’t get through Graham. I don’t know why. But you might be one of those people. Sample some of Graham’s actual writing first to find out.

If you just want the core “how to invest” stuff by Ben Graham, it’s simply:

1. The Interpretation of Financial Statements (1937) – $17.84

 

2. Security Analysis (1940) – $34.71

 

3. The Intelligent Investor (1949) – $19.39

So we’re talking a $75 set.

The usual caveats for any decades old academic / technical writing applies to these books.

All the information in them is dated. This isn’t what Graham would write today. It’s like reading Keynes or something. It’s a classic. But it’s definitely not the way today’s students are introduced to the field.

I get asked which editions of The Intelligent Investor and Security Analysis I prefer. The answer is the 1940 edition of Security Analysis and the 1949 edition of The Intelligent Investor.

Different people have different preferences. Those are mine.

The book I’m giving away in this month’s blind stock valuation contest is the 1949 edition of the Intelligent Investor. To be clear, these are all modern reprints. I don’t own – and am not giving away – collector’s pieces. Although, obviously, copies of the memoirs are “collectible” in the sense that they’ve appreciated in value. I think new copies retailed for $28 in 1996.

Regardless, you should only buy these books if you intend to read them – repeatedly.

Talk to Geoff About Building Your …

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15 Valuation Walkthroughs

A reader sent me this email:

Hi Geoff,

Do you know of a place where I can find walk-thrus of valuation work where they actually include important things to look for when getting started? I’ve been looking for a full case study with some answers to questions that a novice might have but haven’t really found a comprehensive source for that type of thing. Find lots of valuation work out there on SumZero etc.  But most seems to be for advanced users. Any ideas?

Thanks,
Andrei

Here are 15 places where you can find valuation walkthroughs:

1. Value Investors Club (just look at the ideas older than 90 days)

2. My 2 Letters to the Bancinsurance Board of Directors

3. Raymond James’s Bancinsurance Presentation

3. Warren Buffett: Walt Disney and Warren Buffett: Washington Post

4. International Value Investing Ideas like PaperlinX and Danier Leather

5. Mason Wartman’s Report on Stanley Furniture

6. Tim Welland’s Seeking Alpha Write-Up on Aerosonic

7. Ben Graham’s 1949 Edition of The Intelligent Investor – Chapter 10.

8. The 10 Lectures at The Rediscovered Benjamin Graham Website

9. Investor Questions Podcast #19: What is Exxon Worth?

10. Investor Questions Podcast #9: How Do You Calculate a Bank’s Intrinsic Value?

11. Investor Questions Podcast #6: How to Calculate an Insurance Company’s Intrinsic Value?

12. Investor Questions Podcast #1: Intrinsic Value Walkthrough

13. Whopper Investments: Meritage Hospitality Write-Up

14. Greenbacd: Ben Bortner’s Guest Post on Seahwak Drilling

15. Street Capitalist’s Gyrodyne Post

Talk to Geoff About Valuation Walkthroughs…

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International Value Investing: Turbotec (TRBO:LN) – United Kingdom

Richard Beddard of the Interactive Investor Blog brought this company to my attention through Twitter. Here’s a short blog post about Turbotec.

This is actually an American company listed in London. A few years back, its sole shareholder unloaded half the company by floating it in the U.K. There’s since been a dispute with the shareholder, Thermodynetics, which is discussed below.

The company has a market cap of $6 million. The stock price in U.S. dollars is 47 cents per share.

That’s 29.5 pence.

Although the shares are priced in pence – the sales, assets, earnings, and cash flows are all in U.S. dollars. So, you really need to translate pence to cents every time you check the price on this stock.

That’s regardless of whether you are in the U.K. or not. To British investors, this is effectively an American stock. The stock may be quoted in pence, but the business is run in dollars. So British investors are still exchanging their pence for cents when they buy and their cents for pence when they sell.

For non-U.K. investors: “GBP” means Great British Pounds; “GBp” means Great British pence. A pence is 1/100 of a pound. So watch your shift key.

The company is moving to a new manufacturing facility in North Carolina. This had been a New England company. The new location makes a lot more sense.

Regardless, the mortgage associated with the North Carolina property more or less wipes out the company’s net current assets.

However, the company still has about $0.86 a share in tangible book value versus a $0.47 share price. Check the latest quote and the GBP to USD exchange rate when you read this.

So we’re talking about a profitable company selling at a 45% discount to its tangible book value.

Interesting.

Turbotec (TRBO:LN) – Reports

Below, I’ve quoted from the subsequent events section of the annual report. These are the two material events you might miss out on if you just read the 2010 financial statements. I’ve also translated the court award into U.S. dollars, because again, that’s how you should value a company that keeps its assets and earnings in U.S. dollars.

In April 2010, the Company completed the purchase of an approximately 100,000 square foot facility and an adjacent 5.46 acre parcel of undeveloped land in Hickory, North Carolina for $2,768,750. The company plans to relocate its manufacturing operations to this facility commencing in late fiscal year 2011. The purchase was financed in part with a mortgage from the Company’s existing bank in the amount of $2,215,000. The mortgage has a twenty five year amortization schedule with equal monthly payments of principal with a five year term and bears interest at a floating rate linked to the bank’s prime rate.

And there was also a court case:

“On 10 May 2010 the Company was notified that it was successful in its defence of the claim brought by Thermodynetics, Inc. in relation to the payment of administration

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Coming Up With a List of U.S. Stocks

A reader sent me this email:

“I was curious about how you go about looking at companies A through Z. Obviously there are many ways to do that and many sites that can be used, but what is your method? Which site do you use for domestic securities? And do you have a list of all publicly traded companies that you go off of?”

For complete lists of the stocks in any country, you always start by going to their stock exchange.

Here’s a list of the world’s stock exchanges.

Now back to your question. How to find stocks in the U.S…

The U.S. has quite a few really big stock exchange websites. There’s the NYSE, NASDAQ, AMEX, and OTC Market.

Technically, the OTC Market isn’t a stock exchange. But for the purposes of generating this list, it’s just as good. And the OTC Market website is at least as good as NYSE and NASDAQ. Probably better. It’s definitely easier to navigate and much more geared to actually researching stocks.

There are so many stocks in the U.S. it can be difficult to go through them using the various U.S. stock exchange websites.

However, coverage of U.S. stocks is so good by screeners that you’ll almost never miss an interesting U.S. stock using one of the better screeners out there.

A good site for U.S. stocks is Morningstar.

They have a screener for paid subscribers that covers just about every U.S. stock. So, if you tell the screener you want just U.S. public companies with a market cap of at least $2 million – to throw out stocks that are inactive but still listed on the screener – Morningstar will spit out a list of 6,267 stocks. That’s more than enough stocks for most people!

And these are just American companies. There are tons of foreign companies traded in the United States. We’re not talking about them. Even if we just look at U.S. companies with publicly traded stock we’re talking about over 6,000 choices.

My advice is to pick small sections of this 6,000+ stock universe and then work your way through them.

Let’s say you’re from the state of Illinois. If we do the same search for domestic stocks with at least a $2 million market cap headquartered in Illinois we get 209 stocks. Morningstar says the biggest Illinois based stock has a market cap of $78 billion. And the smallest has a market cap of $2 million. There are more than a dozen Illinois stocks with a market cap under $10 million.

That’s tiny. Let’s go a little bigger.

There are 58 Illinois stocks with a market cap under $100 million. If Illinois was my home state, I’d pretend those 58 stocks were my whole universe for a couple days and just go through that list from A to Z.

This works well for a lot of states. New Jersey has even more public companies than Illinois: 247. The biggest …

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Investing in Turnarounds

A reader sent me this email:

Do you invest in turnarounds / cyclicals?

I came across Furniture Brands (FBN). Avg. FCF over 10 years is $75 million. Current EV is $280 million. Of course, last two years were horrible from an earnings perspective…However, FCF was not bad in those years…Trades at 1.2x tangible book value and 0.2x sales…The low ROE even in good years tells me this is not a great business…thoughts appreciated.

I wouldn’t pay a dime more than tangible book for any company involved in making furniture. In fact, I’d want about a 33% discount to tangible book to even get interested in that sort of thing. I think invested assets in the furniture industry are worth far less than book. The more likely capital is to stay invested in the furniture industry, the less likely I am to value that capital at anywhere near book value.

I don’t think of myself as investing in turnarounds or cyclicals. But others might disagree. Was Barnes & Noble (BKS) a turnaround? I don’t think so. It was more the expectation of horrible things happening in the future than the present that was weighing on that stock.

However, I will invest in stocks that are temporarily unloved because of the state their industry is in. So I would buy something like Masco (MAS) or Mohawk (MHK) at the right price. I bought Omnicom (OMC) when the advertising industry looked bad (early 2009). And it’s only because I have a pretty high hurdle rate – and a micro cap bias – that I don’t own Fair Isaac (FICO) right now. I’d say each of those companies at one point had a low stock price mainly – though not exclusively – because it was the wrong time in the cycle for their industry. But I want a good long-term record and good operations relative to peers. I don’t want to invest in something that’s gone downhill compared to competitors. But, if I think their competitive position is strong – it’s just the industry that’s weak – I would definitely consider buying something like that.

The thing with Furniture Brands is that all the stocks in the furniture industry are really, really cheap. I mean, I posted Mason’s report on Stanley (STLY) on the blog and Chromcraft Revington (CRC) shows up in Ben Graham net/net screens. My problem is that furniture looks a bit like textiles when Buffett bought Berkshire Hathaway (BRK.B). Textile production was moving from New England to the South back then. And there were very good, very permanent reasons for that happening. Not permanent for the South keeping the mills but permanent for the North losing them.

Furniture – unlike textiles – is a consumer product. But furniture is tricky because like appliances, computers, flat screen TVs, etc. it’s a product where the customer often does an exhaustive search. I don’t like businesses where the customer rationally considers alternatives. Furniture isn’t a repeat purchase business. Brand loyalty is …

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How Much Would You Pay for This Stock? – Blind Stock Valuation #1

In an earlier post, about how to value a business, I said:

Here’s my advice for how to really learn to value a stock. Start with a stock that’s pretty easy to value and completely unknown to you. Don’t look at the stock price! Just try to value the whole company.

Ideally, you should be able to black out the company name, business description, and stock price on a Value Line page and still be able to come up with an approximate appraised value for the business within 10 minutes.

So here’s a blind trial I’ve prepared…

How much would you pay for this stock?

Answer by emailing me your per share appraisal. In other words, tell me how much the stock is worth. I’ll pick the best email answer I get and give the winner a copy of my favorite version of Benjamin Graham’s The Intelligent Investor.

You have until the end of January to send me your email.

Talk to Geoff About Blind Stock Valuation…

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What Broker to Use When Buying International Stocks

The author of a great value investing blog, Value Uncovered, asked me this question on Twitter:

“What broker do you use that supports buying international stocks?”

I use a full service broker.

But I would recommend most people interested in buying foreign stocks start by looking at Noble Trading and Interactive Brokers.

As far as I know, any full service broker should be able to buy you any stock you want. The question for full service brokers is whether they want to buy you any stock you want and then how much they’ll charge. The easiest answer to both these questions is to personally know a broker at one of the full service firms beforehand and then give him your account with a clear understanding of exactly what it is you want to do. You don’t need advice. Just execution.

Now, you need to think of things from the other guy’s perspective.

If you’re a super concentrated, go anywhere value investor like me you have two problems. One is a problem for the investor. The other is a problem for the broker. The investor’s problem – my problem – is that I want to buy any stock anywhere and the long list of fees normally tacked on to this sort of thing can pile up to a horrendous dollar amount per trade. However, since I don’t hold more than 5 stocks at once – from the broker’s perspective – I make a horrendously low number of trades each year.

You – the investor – need to be assured you won’t have all your gains eaten up by commissions. But the broker needs to be assured the account will be worth his time.

It would be heartless of you to ask a full service broker to take on this kind of account without giving him 1% of each round trip in return (0.5% of each order). It would be greedy for him to ask for more than 2%.

You can work something out in that range. For example, if you have a $200,000 portfolio that you want to put into no more than 10 stocks at once, each order will be $20,000. If you turn your portfolio over once a year, you’ll be placing 20 orders – each for $20,000 – each year (after the first). That means you can pay $100 to $200 on each order (0.5% to 1% of each order) in commissions to your broker.

Obviously, if you have more money to invest and hold fewer stocks (as I do), you can pay a higher commission on each order. At my level of concentration – just 5 stocks – you can pay $200 to $400 on each order and still be paying your broker only 1% to 2% of your $200,000 portfolio each year.

Although numbers like $400 an order and 2% of assets a year sound obscene, they really aren’t if the service you are getting is worth it.

If a brokerage firm appeared …

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Warren Buffett and Western Insurance

A reader asked me this question:

…your last article on Gurufocus regarding 50% returns and microcaps…seems (to) have sparked a lot of responses on it. Some are off the mark or just misinterpreting the point of the article. Other comments provide good points. Not sure if you were planning on responding to all the various comments. There is a difference between cigar butt approach and hold forever approach. Personally I think your approach considers the downside based on your checklist…Maybe discussion on margin of safety in the approach should be mentioned…your thoughts?

Regarding the difference between the cigar butt approach and the hold forever approach, Warren Buffett was not using a cigar butt approach to invest in micro caps in the 1950s. He was just focused on decent, dependable, dirt cheap, neglected stocks. The companies Buffett invested in for his own account in the 1950s were not cigar butts. He just didn’t plan to hold them forever. He sold out of one cheap stock whenever he found a cheaper one.

But these weren’t low quality businesses.

Let’s take a look at one…

Western Insurance

I found some strange things when I was 20 years old. I went through Moody’s Bank and Finance Manual, about 1,000 pages. I went through it twice. The first time I went through, I saw a company called Western Insurance Security Company in Fort Scott, Kansas…Perfectly sound company. I knew people that represented them in Omaha. Earnings per share $20, stock price $16…I ran ads in the Fort Scott, Kansas paper to try and buy that stock – it had only 300 or 400 shareholders. It was selling at one times earnings, it had a first class (management team)…I’d never heard of Western Insurance Services until I turned that page that said Western Insurance Services. It showed earnings per share of $20 and the high was $16. Now that may not turn out to be something you can make a lot of money on, but the odds are good. It’s like a basketball coach seeing a guy 7’3” walk through the door. He may not be able to stay in school, and may be very uncoordinated, but he’s very large. So I went down to the Nebraska Insurance Department, and I got the convention reports on their insurance companies, and I read Best’s. I didn’t have any background in insurance. But I knew I could understand it if I worked at it for a while. And all I was really trying to do was disprove this thing. I was really trying to figure out something that was wrong with this. Only there wasn’t anything wrong. It was a perfectly good insurance company, a better than average underwriter, and you could buy it at one times earnings. I ran ads in the Fort Scott, Kansas paper to buy this stock when it was $20. But it came through turning the pages. No one tells you about it. You get ‘em by looking.

I would put something …

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