Most investors are content to rely on reported earnings, even though they are subject to creative accounting, massaging by management or outright manipulation.
Earnings are an accounting construct. Investors don’t get paid with earnings — they get paid with cash. When you invest in a company, it will pay you back in the future via dividend payments or stock repurchases, both of which are paid in cash.
A Company as a Cash Processor
Before we get into formulas and financial statements, let’s step back and look at the basic functions of a business.
First, a company sells its product, generating revenues. After collecting cash from its customers, the firm pays the costs of doing business, sending cash out to pay salaries, rent, taxes, etc.
After expenses are paid, the remaining cash can be reinvested in the business. Short-term assets like inventory and receivables (called working capital) get used up and need to be replenished. Long-term assets like buildings, plants and equipment (capital expenditures, or capex) need to be expanded, repaired and replaced as they get older or as the business grows.
Now that the company has paid its bills and reinvested in itself, hopefully it has some money left over. This is the free cash flow to the firm (FCFF), called such because it’s available (free) to pay out to the firm’s investors, generally comprised of two groups, bondholders and stockholders. Bondholders get paid first, stockholders get paid last.
So, after collecting revenue, paying expenses (including taxes), investing in the business, making interest and principal payments to bondholders and maybe borrowing more money from bondholders, the amount left over is the free cash flow to equity (FCFE). It’s available to be paid out to the only people who haven’t gotten paid yet, the equity owners (stockholders).
Now, at this point the company’s board of directors may or may not decide to distribute the FCFE to shareholders. They might pay out some or all of the FCFE as dividends, or they might choose to keep some or all of it in the company for future projects. But the point is, the FCFE is the source of any payouts to stockholders, so these are the cash flows that are relevant to calculate the value of a stock.
Not surprisingly, to calculate FCFF, you’ll need the company’s financial statements. FCFF can be calculated using a number of formulas, but this one is probably the most straightforward:
FCFF = CFO + Int * ( 1 – T ) – Inv LT
CFO = cash flow from operations (cash flow statement)
Int = net interest (income statement)
T = tax rate (notes to financial statements)
Inv LT = investment in long-term assets (cash flow statement, financing activities)
Don’t forget the Int * ( 1 – T ) term, which is probably the most confusing part of the equation. It accounts for the fact that interest on debt shelters a portion of income from taxes. The Int * (1-T) term reflects tax shield.
Most of the hard work went into calculating FCFF, so if you want to go on to calculate FCFE, you can use the following formula:
FCFE = FCFF – Int * (1-Tax rate) + net borrowing
The price of a stock today is simply the sum of its future cash flows when those cash flows are put in today’s dollars. FCF can lead you to the value of the firm as a whole, or to the value of just one share of the company.