Extrapolation can be a very dangerous word. It can lead us down very misleading and potentially destructive paths. For instance, the Congressional Budget Office (CBO) often extrapolates projected budgets from recent data – we all know how accurate their predictive ability can be. It is a dangerous and common mistake to do this when analyzing a company’s financials. I have made this mistake many times much to my regret.
I use Google to illustrate this point. As most of us know, Google is the poster child for free cash flow. It’s a tremendous business with an incredible model. Think about it – the company holds a dominant market share in a rapidly growing industry that requires very little capital investment to grow. This is a text book formula for generating tons of cash. Anyway, there was an interesting article in Barron’s this past issue discussing the attractive opportunity for investment. I agreed with the premise of the article with one small exception. There was a reference to the fact that GOOG was generating approximately $27 per share in free cash. This number isn’t hard to calculate – see the statement of cash flow below. The company generated $9.3 billion in cash from operations minus $800 million in capital expenditures. This number ($8.5 billion) divided by 319 million shares outstanding gives us $27 per share. At a recent market quote of $477, the stock is trading at 17.6X FCF. This is not outrageous. My exception to this point is – will this be sustainable?
Statement of Cash Flow:
2009 | 2008 | 2007 | 2006 | 2005 | |||||||||||||||||||||||||||||||||||||||||||
Period End Date | 12/31/2009 | 12/31/2008 | 12/31/2007 | 12/31/2006 | 12/31/2005 | ||||||||||||||||||||||||||||||||||||||||||
Period Length | 12 Months | 12 Months | 12 Months | 12 Months | 12 Months | ||||||||||||||||||||||||||||||||||||||||||
Stmt Source | 10-K | 10-K | 10-K | 10-K | 10-K | ||||||||||||||||||||||||||||||||||||||||||
Stmt Source Date | 02/12/2010 | 02/13/2009 | 02/15/2008 | 03/01/2007 | 03/16/2006 | ||||||||||||||||||||||||||||||||||||||||||
Stmt Update Type | Updated | Updated | Updated | Updated | Updated | ||||||||||||||||||||||||||||||||||||||||||
Net Income/Starting Line | 6,520.45 | 4,226.86 | 4,203.72 | 3,077.45 | 1,465.4 | ||||||||||||||||||||||||||||||||||||||||||
Depreciation/Depletion | 1,240.03 | 1,212.24 | 807.74 | 494.43 | 256.81 | ||||||||||||||||||||||||||||||||||||||||||
Amortization | 284.28 | 287.65 | 159.92 | 77.51 | 37.0 | ||||||||||||||||||||||||||||||||||||||||||
Deferred Taxes | -268.06 | -224.65 | -164.21 | 0.0 | 0.0 | ||||||||||||||||||||||||||||||||||||||||||
Non-Cash Items | 1,073.78 | 2,055.44 | 489.44 | -112.83 | 656.47 | ||||||||||||||||||||||||||||||||||||||||||
Changes in Working Capital | 465.72 | 295.32 | 278.8 | 43.96 | 43.74 | ||||||||||||||||||||||||||||||||||||||||||
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Cash from Operating Activities | 9,316.2 | 7,852.86 | 5,775.41 | 3,580.51 | 2,459.42 | ||||||||||||||||||||||||||||||||||||||||||
Capital Expenditures | -809.89 | -2,358.46 | -2,402.84 | -1,902.8 | -853.04 | ||||||||||||||||||||||||||||||||||||||||||
Other Investing Cash Flow Items, Total | -7,209.32 | -2,960.96 | -1,278.75 | -4,996.35 | -2,505.16 | ||||||||||||||||||||||||||||||||||||||||||
Cash from Investing Activities | -8,019.21 | -5,319.42 | -3,681.59 | -6,899.15 | -3,358.19 | ||||||||||||||||||||||||||||||||||||||||||
Financing Cash Flow Items | 90.27 | 159.09 | 379.21 | 581.73 | 0.0 | ||||||||||||||||||||||||||||||||||||||||||
Issuance (Retirement) of Stock, Net | 143.14 | -71.52 | 23.86 | 2,384.67 | 4,372.26 | ||||||||||||||||||||||||||||||||||||||||||
Issuance (Retirement) of Debt, Net | 0.0 | 0.0 | 0.0 | 0.0 | -1.43 | ||||||||||||||||||||||||||||||||||||||||||
Cash from Financing Activities | 233.41 | 87.57 | 403.07 | 2,966.4 | 4,370.83 | ||||||||||||||||||||||||||||||||||||||||||
Foreign Exchange Effects | 10.51 | -45.92 | 40.03 | 19.74 | -21.76 | ||||||||||||||||||||||||||||||||||||||||||
Net Change in Cash | 1,540.92 | 2,575.08 | 2,536.92 | -332.5 | 3,450.3 | ||||||||||||||||||||||||||||||||||||||||||
There two issues in which to be aware when drawing conclusions from the financial statement above. First, the most recent year’s cash flow number may be the exception rather than the rule. Notice the sharp drop off in capital expenditures from 2008 to 2009. This has a dramatic effect on free cash flow. This might be a good cap exp level to use in the future, but it definitely requires further scrutiny. Secondly, there issue a more subtle issue happening with Google’s future strategy. They are relying more and more on acquisitions into new spaces. They have tons of cash to spend, so it isn’t one of available capital. But this new strategy directly impacts cash flow. If a company is making acquisitions every year, I subtract that number from free cash to arrive at an adjusted cash flow number. For instance, If GOOG generated $8.5 billion in cash but spent $2 billion on acquisitions; I’ll use $6.5 b as the adjusted FCF number. So in this case, the text book definition of cash flow may be overstated.
I actually find Google to be a potentially attractive investment. Even after the adjustment, they still throw off tons of cash. But basing valuation on one year’s results may lead you down the wrong path.
Disclosure: none
