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I'll tack on to Mike's comment...

I work primarily out of the Statement of Cash Flows (SCF), as cash accounting is a much more accurate method of tracking performance than modified accrual based accounting, which tends to be subject to manipulation. As Mike points out, operational cash flows can swing widely quarter to quarter. Think of your own household...4th quarter is usually your greatest cash-outflow quarter due to the holidays. Businesses, depending on their industry, may also have season variations as well as periodic large changes in working capital accounts. So I use rolling 4-Quarters to smooth out the fluctuations, and then look at the multi-quarter trending of key CF ratios.

I use average basic shares rather than fully diluted shares when doing trending on a per-share basis. I used to use fully diluted just to be conservative in my calcs, until a CFA analyst friend of mine asked me why I was using that instead of average basic shares. Fully diluted includes any possible stock-instrument that can be converted to common shares, to include employee options, unvested RSUs, convertible debt/preferreds and warrants. But most of these will not be converted to company stock until they either vest or the price reaches a conversion price.

Rather than picking out this or that adjustment to earnings, I simply use the Consolidated Funds from Operations, CFFO, as reported. This is the actual cash from operations management had available to them at the end of the period. I then reduce this by any cash distributions made to non-controlling interests (rare) and any dividends paid to preferred shareholders (if any). The Net CFFO remaining is what management has available to them to first pay the common dividend and after that, to put towards investing activities.

For dividend paying stocks with long dividend histories, the best way I've found of valuing the share price...something I normally don't do....is to look at the yield spread with the 10 Year Treasury Bond. The greater the spread, the lower the valuation.

BruceM
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For example i'm using TTM numbers for The Trade Desk (TTD) and change in working capital es -59,950. If i substract this, it turns into a positive. Is this correct or should I treat cashflow numbers as absolute and use the formula's signs (+/-)?

You can have positive and negative changes in working capital, so don't change the sign. Subtract the negative number and you'll get an increase in owner earnings. That's totally fine. Think of it this way: let's say you collected on a bunch of receivables so your current assets went down. That's a good thing. Or maybe your inventory shrank a whole bunch after the Christmas selling season. Or maybe your accounts payable went up because you were able to extend your payment terms. Working capital is just current assets minus current liabilities, so if all other things stayed equal, you'd have a negative change in working capital if a component of current assets went down or a component of current liabilities went up. Either one of these happening means less money is required to be tied up in the business (at least there was this quarter/year).


The second doubt i had arose while looking at some examples and articles, since some did include things like: stock based compensation, deferred taxes, other working capital but these were not in the original definition of the formula.

Yes, that's because "owner earnings" or free cash flow is not a GAAP term. Since it's not specifically defined in GAAP, there are multiple flavors of it. Personally I add back in stock-based compensation since it is a non-cash charge, but then I also use the fully-diluted share count when I do my valuation to get a per share value. Share based compensation is definitely an expense so you want to factor it in somehow. You won't find any single, concrete definition of what free cash flow is.

Another thing I should point out is that the strength of the cash flow statement is it shows you the actual cash going into and out of the business for one particular period, but that's also the cash flow statement's weakness. If a large, one-time event occurs in that period, you'll see it in the cash flow statement but it will likely be smoothed over in the income statement. If it's a one-time or occasional thing (like a large acquisition, or a large fine, or a large build up of inventory right before the holiday season) and you factor it into owner earnings like it will always be there, you'll be misrepresenting owner earnings/free cash flow. What I like to do is look at a period of the last five years and see what owner earnings have done over a span of time, to make sure I'm getting a representative view of the company. When I do my valuation I usually go with a free cash flow estimate that's somewhere in between the completely smoothed-over income statement and the very bumpy cash flow statement


Mike
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I'll tack on to Mike's comment...

I work primarily out of the Statement of Cash Flows (SCF), as cash accounting is a much more accurate method of tracking performance than modified accrual based accounting, which tends to be subject to manipulation. As Mike points out, operational cash flows can swing widely quarter to quarter. Think of your own household...4th quarter is usually your greatest cash-outflow quarter due to the holidays. Businesses, depending on their industry, may also have season variations as well as periodic large changes in working capital accounts. So I use rolling 4-Quarters to smooth out the fluctuations, and then look at the multi-quarter trending of key CF ratios.

I use average basic shares rather than fully diluted shares when doing trending on a per-share basis. I used to use fully diluted just to be conservative in my calcs, until a CFA analyst friend of mine asked me why I was using that instead of average basic shares. Fully diluted includes any possible stock-instrument that can be converted to common shares, to include employee options, unvested RSUs, convertible debt/preferreds and warrants. But most of these will not be converted to company stock until they either vest or the price reaches a conversion price.

Rather than picking out this or that adjustment to earnings, I simply use the Consolidated Funds from Operations, CFFO, as reported. This is the actual cash from operations management had available to them at the end of the period. I then reduce this by any cash distributions made to non-controlling interests (rare) and any dividends paid to preferred shareholders (if any). The Net CFFO remaining is what management has available to them to first pay the common dividend and after that, to put towards investing activities.

For dividend paying stocks with long dividend histories, the best way I've found of valuing the share price...something I normally don't do....is to look at the yield spread with the 10 Year Treasury Bond. The greater the spread, the lower the valuation.

BruceM
Print the post Back To Top