Free Cash Flow, Capital Expenditures and Tax

By Jae Jun

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Foreword

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I wanted to add some additional points on FCF which

I brought up in analysing the Statement of Cash Flows

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before moving onto the future posts on balance and income

statements.

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If a company receives a tax deduction when employees exercise their stock options,

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does this count as cash from operating activities?

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Or if the company defers its income taxes to a later period, does this count as cash from

operations?

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I don’t think so.

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What You Will Learn

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• What is cash flow• The use of FCF• How to use CAPEX• The effect of positive FCF

Disclosure

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I wanted to add some additional points on FCF which I brought up in the Cash Flow

Statement analysis before moving onto the future posts

on balance and income statements.

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Free Cash Flow Capital Expenditures

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The FCF is supposed to be derived from the operations of

the business.

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In the updated version of the intrinsic value spreadsheet, the

FCF number now subtracts deferred taxes and “others”.

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Capital Expenditure Adjustments

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I would say the most difficult aspect of trying to calculate

FCF is

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determining the amount of capital expenditure used to

maintain operations and

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market position versus the amount used for growth.

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A simple example would be to think of a retailer like Wal-Mart.

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In 2008, Wal-Mart spent $14.9 billion on capital expenditure.

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Of that $14.9 billion, 100% of it did not go to opening new

stores or expanding to new emerging markets.

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A certain percentage was used to maintain its current stores.

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The shelves have to be filled, maybe the plumbing needed to be fixed or the walls had to be

repainted.

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The point is to find (or estimate) how much of the

company’s capex is for maintenance which should

then be subtracted from Cash From Operations,

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whereas the capex used for growth should not be

subtracted.

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Calculating these numbers is much easier said than done.

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If you don’t feel inclined to go through so much data (like

myself),

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simply subtracting the given cap ex is an accepted and

conservative practice.

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The reason people go to such lengths to find maintenance

cap ex is to find value a majority of investors cannot

see.

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Understanding the Industry and

Company

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Positive FCF for every company is not possible. That doesn’t mean a company with

negative FCF is bad.

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Positive FCF for every company is not possible. That doesn’t mean a company with

negative FCF is bad.

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One example is the oil industry and within that industry, take a

look at Transocean (RIG).

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A cyclical industry and high cap ex business, yet it’s able to

throw off huge amounts of FCF.

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Transocean and most oil drilling companies forego FCF

in the short term to create immense shareholder value in

the future.

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Conclusion

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Cash is a fact but there are lots of items which can be left out

or moved to another section of the statements.

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Stick with the cash that comes from operations rather than

one time occurrences.

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Going the full length to find the real maintenance cap ex will

give you more investment opportunities.

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It’s always a good idea to understand the business’s

cash strategy.

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Old School ValueJae Jun (jae.jun@oldschoolvalue.com)

http://www.oldschoolvalue.comOld School Value improves your

investment decisions and performs deep fundamental analysis and

valuation for you. Just like a personal stock analyst.