Cost of Capital- 50% of the Valuation Puzzle- (Part 1- Cash Flow from Operations)
These past several weeks saw the stock of one of the world’s largest firms plummet, with only minor, as yet, effect on cash flows. It was of course risk, or more correctly, impending risk to cash flows, that worried investors in both equity and fixed income assets of BP.
While surprises cannot be predicted, security analysts must constantly evaluate all risks, for even in BP’s historic 10Ks, we learned the extent of their insurance coverage for an event of this magnitude; and insurance adequacy is but one of the 60+ variables we look at in constituting the cost of equity, the required return shareholders expect.
We will learn more of these other risks in later blogs, any one of which could cause a seismic shift to valuation. Today, we will look at the risk to cash flow from operating activities. We will see, also during a later blog, we measure consistency of many factors, operating cash flow included.
The operating cash flow of the company in our credit spreadsheet is from the form 10K’s and 10Q’s. Cost of capital is penalized if operating cash flow (OCF) is negative. The greater the number of periods for which OCF is negative, the greater then penalty. For some items such as postretirement benefits and other retirement obligations, we include the net cost for the period rather than actual cash outflows, in order to separate what we view as financing of these obligations from the operating cost component.
Adjustments to the operating cash flows may be made to the extent current reporting obscures the ability of the analyst to place a correct economic valuation on the enterprise. For example, the sale of accounts receivable would be picked up under operating cash flows, if reported as a financing activity. Capitalizing interest would be reclassified from investing to operating cash flow, as might interest, dividends and taxes that have been reported as investing or financing activities.
The signing of capital leases may artificially enhance operating cash flows. This is because that while the interest portion of capital leases are counted as an operating activity, the reduction in the lease, through those principal payments, are reported as a financing activity. We typically make adjustments to reported operating cash flow to remove items we consider nonrecurring and include those we consider recurring, so the historical financial ratios will be more indicative of future performance. These adjustments cover items including discontinued operations; effects of natural disasters; gains or losses on asset sales and sale/leasebacks; and one-time charges for asset write-downs, restructurings and plant shutdowns.
Other adjustments could be made to allow for better comparability among peer companies and to derive actual cash from operating activities which may be included as financing or investment activities. The nature of any adjustment is to more accurately reflect the ability of the enterprise to satisfy its obligations and enhance forecasting. When making adjustments, they must be consistently applied or comparability will be lost.
Typically, companies need to generate cash from their operations in order to survive. However, businesses may from time to time show negative operating cash flows in trough years, which should be offset by larger positive operating cash flows in good years. Similarly, a company may occasionally have, due to adverse business conditions or changes in balance sheet items, a year in which cash from operations is negative. However, an enterprise cannot sustain negative operating cash flows for long periods without obtaining additional financing, liquidating assets, or falling into bankruptcy.
If the firm’s business is contracting, the firm’s executives will attempt to extract cash through “working” the balance sheet, in which case we will see considerably stronger operating than power operating cash flows (which adjust for a normalized balance sheet) and net income reported under GAAP. In these instances, power operating cash flow metrics would be granted greater weight than operating cash flow metrics.
For a complete discussion on this topic as well as all metrics in our credit spreadsheet, please order “Security Valuation and Risk Analysis,” Kenneth Hackel, C.F.A, at Amazon and all online bookstores.
Only CT Capital LLC has the proprietary free cash flow-based return on invested capital (ROIC) and very detailed cost of capital credit-based models to properly evaluate these most important yardsticks. All other approaches fall short as they do not accurately reflect the underlying financial profitability and stability of a firm, its growth potential and value enhancement level
