Hello everyone, this is the fourth and last video of the series about investing like Warren Buffett where we try to find out what we have to look for when deciding which company to invest in and we learn how to read those complicated financial statements that usually look like a mountain of numbers with little meaning. My name is Rick and in today’s video we are going to learn how to read probably the most important financial statement which is the Cash Flow Statement. Let’s get started.
Free Cash Flow
The Cash Flow Statement is probably the most important financial statement when choosing which company to invest your money in and this is because from the Cash Flow Statement investors can calculate the most important value to analyze a company, which is free cash flow. Free cash flow (FCF) is the cash left over after a company pays for all its operating expenses, namely the expenses for the operation of the business, and capital expenditure, which is money used to pay for assets like plants and equipment. So it’s the Cash that remains available to the company.
Now the Free Cash Flow is not directly written in the Cash Flow Statement but can be calculated. It might be a little tricky to calculate it precisely, but simply put the Free Cash Flow is calculated taking the Operating Cash Flow of the company, which is the amount of cash that the company generated with its business operations, and subtracting the Capital Expenditures, which as I said is the money the company uses for its physical assets such as property, plants or equipment. We will see later how to calculate it, for now just know that it’s much easier to just go on a website like Morningstar.com and get the value already calculated from somebody else.
Generally speaking, investors love companies that produce plenty of free cash flow. This is because Free Cash Flow signals a company’s ability to pay debt, pay dividends, buy back stock and, most of all, to make the business grow in the future.
Many investors, like Warren Buffett or Bill Ackmann, prefer using free cash flow instead of net income to measure a company’s financial performance, because free cash flow is more difficult to manipulate than net income. What they do is they use Free Cash Flow to calculate the intrinsic value of the company. The intrinsic value of the company is the real value of the company, from the investor’s perspective, in consideration of the future growth of the company that the investor expects to see and the free cash flow helps you understand that because the best way to evaluate a company is to see how much cash the company produces for the shareholders.
This intrinsic value that investors calculate from the free cash flow is different from the price of the stock, therefore you are able to compare the intrinsic value with the price of the stock and see if the company is undervalued or overvalued at the moment.
If the intrinsic value, namely the real value, is lower than the price of the stock, then the company is overvalued and it’s not worth paying the stock price and buying it. If on the other hand the intrinsic value is higher than the price of the stock, then it means that you could buy the stock at a price that is lower than the real price it should have. So in that case you need to take a deeper look and try to understand why it trades at a deep discount and there might be many reasons. It could be that there is a national or international crisis, and everybody starts emotionally selling off stocks and all prices go down, like this year, and in this case it might be a good opportunity to buy the stock, or it could be that there is some problem within the company that you still don’t know about but the rest of the public does, and therefore they sold and the price dropped.
Now you might ask “How do I calculate the intrinsic value of a company?”. The process used is the so-called discounted cash flow analysis and, in order to explain this process, I would need a video alone for it. So, I’m not going to explain the discounted cash flow analysis here in this video, but if you are interested I have a google sheets file where I calculate it and if you want I could make a video on how I created this table and how the analysis works. Just let me know in the comment section below if that could be of interest for you.
For now, just remember that the most important Cash Flow value is the Free Cash Flow and now let’s move on to some other parameters that can be directly found in the Cash Flow Statements, unlike the Free Cash Flow, and that still play some important role in the analysis of companies for stock investments.
Oh and by the way, if you haven’t already don’t forget to subscribe to my channel and also take a look at the other videos of this series – I can link one of them here and I’ll link all of them in the description below – because then you can have a whole overview of how to read and interpret financial statements “Buffett Style”.
Cash Flow Statement
If you’ve seen the last few videos already, you should have noticed that the Income Statement and the Balance Sheet don’t really give you any information about how much money actually flows within the company. The Income Statement gets closer to it because it shows the net earnings of the company, but that doesn’t really tell you how much money is in the company’s pocket. Since most companies use an accrual method of accounting as opposed to a cash method, and therefore sales are booked when the goods walk out the door and not when the money gets in, it has become necessary to keep separate track of the actual cash that flows in and out of the business, and the Cash Flow Statement was created exactly for this purpose. It doesn’t tell us if a company is profitable or not – for that we have an Income statement and Balance sheet – but it tells us if the company is bringing in more cash than it is spending.
So, in the last few videos we used the official 10k of Coca Cola to describe the other financial statements. This time, in order to see how the Cash Flow Statement works and what are the important items, let’s use Morningstar.com. So you just need to go to morningstar.com and type KO, which is the Ticker of Coca Cola, in the bar on the top left. You will land on a page that contains a lot of useful information about the company, like general data of the company and the stock as well as detailed financial information and articles written by Morningstar analysts. But now, let’s focus on the Cash Flow Statement therefore let’s click on “Key Ratios” and then on “Full Key Ratios Data”. Chrome will open another tab that shows right away all the important financial data of Coca Cola. Now, most of these data comes from the income statement, like Revenue, Net Income and so on, as well as from the Cash Flow statement, like Operating Cash Flow, Cap Spending and Free Cash Flow. But now we want to focus solely on Cash Flow, therefore let’s click on financials and then let’s choose Cash Flow. Now, first thing I’d like you to notice is that Cash Flow Statements are divided in 3 sections:
Cash Flow from operating activities, Cash Flow from investing activities and Cash Flow from financial activities. Now let’s describe them for a moment one by one.
- Cash Flow from operating activities as the name suggests contains all Cash Flows, in and out, that are generated from operations. The first item is something you already know well if you watched my video about income statements and that is the Net Income or Net Earnings. This is exactly the value that you find in the income statement and the Cash Flow Statement starts from this value. So the company has received a total of 9.8 billions of dollars in Net Income in 2021, but that doesn’t mean that at the end of the year they had 9.8 billions of cash, because there have been other cash flows due to operations, and this is all reported here in these items. So you start from the net Income, then you have the Depreciation and Amortization of plants and equipment and then all other operating gains or charges. The sum of all these cash inflows and outflows gives the Net Cash provided by operating activities, which was 12.625 for Coca Cola in 2021. Remember this value because we’ll use it to calculate the Free Cash Flow.
- Cash Flow from investing activities: here you find all Cash Outflows due to investments that the company did. So summing up all the cash flows from investing activities you get the Total Cash Flow from investing operations or net Cash used for investing activities
- The last one is the Cash Flow from financing activities: it includes all inflows and outflows of cash related to financing activities, like the payment of dividends, as well as Cash from selling or buying of company stock and selling or buying Bonds. Summing all these items you get the Total Cash Flow from financing activities.
Summing together the 3 points we get the company’s Net Change in Cash. which for Coca Cola in 2021 was this 2.915, or 2.9 billion dollars.
Let’s go now a little bit more in detail through these 3 components of the Cash Flow Statement. Let’s start with the Cash Flows from operating activities.
Cash Flow from Operating Activities
Now, apart from the Net Income, that we already discussed in the video about Income Statement, the first item you see here is Depreciation & amortization. The cost of business assets, for example the machines that Coca Cola uses to bottle the cola or to mix the ingredients, or for example the Trucks used to distribute the bottles all over the country, are expensed each year over the life of the asset in the income statement, so that’s why in the Cash Flow Statement we need this item called Depreciation & Amortization to even out. To make it clear, let’s say that Coca Cola buys a truck for 400.000$ and the taxable lifespan of this truck is 10 years. Coca Cola will then report a cost of 40.000$ each year for the next 10 years in the Income Statement. Now be careful, I said Income Statement, not Cash Flow Statement. In the Income statement the Net earnings are calculated and if the company counts 40.000$ expense every year for the truck they manage to reduce the net earnings and get a tax deduction. But of course we know that they don’t really spend 40.000$ per year for 10 years, in reality they just spend 400.000$ at the beginning and that’s it. That’s why we have the Cash Flow Statement, which reports the exact amounts of cash flows that actually took place every year.
So since we start the cash flow statement with the Net Income, that in the income statement was obtained deducting a yearly Depreciation & amortization that didn’t actually take place as Cash Flow, here in the Cash Flow Statement this Depreciation & amortization is added back to the Net Income as a positive value.
Now, after Depreciation & amortization another item which is worth mentioning is Inventory. We already talked about the inventory in the income statement video, and we said that the inventory is represented by the products that the company has and stores in its warehouses ready to sell. Now, in the Cash Flow Statement you just see the value of the new Inventory which is bought or sold in comparison to the year before. So you don’t have an overview of the total inventory but only of the delta, namely the difference, from the previous year.
Besides Inventory, other items that are worth mentioning are Accounts receivable, which is money owed to the company that flowed that year in the company, Accounts payable, which on the contrary was money owed by the company which flowed out of the company that year, and prepaid expenses, which are upfront payment for an expense, such as an annual insurance payment, that a company has not yet incurred.
Cash Flow from Investing Activities
Now let’s move to Cash Flow from Investing Activities. Here we find right away an item which is incredibly important and which is used to calculate the free Cash Flow. This is the so-called capital expenditure, which here is noted as Investments in property, plant and equipment. So what are capital expenditures? Capital expenditures are money spent by a business on acquiring or maintaining fixed assets, such as land, buildings, and equipment, which are expensed over a period of time greater than a year through depreciation and amortization. Buying a new track for Coca Cola is a capital expenditure. The value of the track will be expensed through depreciation over its life cycle. On the contrary, the gasoline used is a current expense with the full price deducted from Income during the current year and is not considered a capital expenditure.
Now, to make it short, not having capital expenditures, or keeping them low, is one of the secrets to getting rich for a company. Many companies must make huge capital expenditures to stay on the market. If these Expenditures remain high for a high number of years, it can start having a deep impact on earnings. This is the reason why Buffett never invested in telephone companies that have huge capital expenditures.
A company with DCA usually uses a small portion of its Earnings on Capital Expenditures for continuing operations.
Let’s make some examples with average values over the 10 years between 1997 and 2007:
- Coca Cola (Buffett’s choice)
Earnings: 20.21$/Share; Capital Expenditures: 4.01$/Share (19% of total Earnings)
- Moody’s (Buffett’s choice)
Earnings: 14.24$/Share; Capital Expenditures: 0.84$/Share (5% of total Earnings)
- GM, General Motors (Buffett avoids it)
Earnings: 31.64$/Share; Capital Expenditures: 140.42$/Share (444% of total Earnings)
- Goodyear (Buffett avoids it)
Earnings: 3.67$/Share; Capital Expenditures: 34.88$/Share (950% of total Earnings)
Now you might ask: If GM and Goodyear used respectively 444% and 950% of their earnings in capital expenditure, where did all the extra money come from? Well, it came from Bank Loans and selling tons of new debt to the public. Such actions increase debt, which increases spend on interest payments, which is never a good thing.
Historically, Companies with a DCA use a smaller percentage of their Net Income for Capital Expenditure. Usually it should be <50% to show that the company might have a DCA, but the smaller the better. If it is <30% or <25%, and it is constantly so, most likely the company has a DCA. Now, we don’t need to go over every item of the Cash Flows from Investing Operations because the Capital Expenditure is the most important. But right now I can already show you how Morningstar calculates the Free Cash Flow, because they do it based on the operating Cash Flow, which is the result of the first section and for Coca Cola in 2021 was 12,625, and the Capital Expenditure, which in 2021 was 1,367. So if you subtract 1,367 from 12,625 you obtain 11,258, or 11 billion dollars. This was the Free Cash Flow of Coca Cola generated in 2021. This number was the Cash that Coca Cola had available, on hand, to do as it pleased like paying dividends to its shareholders, investing in the growth of the company or buying back stocks. So always remember the importance of Free Cash Flow and its relation to operating Cash Flow and Capital Expenditure.
Cash Flow from financing Activities
So now let’s move on to the Cash Flow from financing Activities. So now the company has had a net Income, has paid the capital expenditures and all the rest and it’s given the possibility to use the remaining Cash Flow, the Free Cash Flow. Some of this Free Cash Flow was used for investments in the growth of the company, and this can be seen in the section 2 on the investing activities, but part of it is used then to pay dividends or to buy back stocks. Let’s see what Coca Cola did in 2021, looking at the Cash Flow Statement in Morningstar, but of course we could have done it using the official 10k of Coca Cola as well, in 2021 Coca cola did the following:
- They paid out 7.252 Mio. $ in Dividends,
- They issued new Coca Cola Stocks for a total of 702 Mio. $ and they repurchased 111 Mio. $ of their own stock
- They issued 13.094 Mio.$ of new debt and repaid 12.866 Mio.$ of old debts
This gave the company a net minus from financing activities equal to -6,786 Mio. $. This means that with these financing activities Coca Cola reduced their Free Cash Flow. Now, in 2021 and 2020 Coca Cola didn’t buy back a lot of shares, but if you look at the years before you’ll see that usually they buy back their stock much more than they issue new stock or sell their stock. This is something that Buffett likes in a company, when the company uses excess cash to buy back the company’s shares instead of using it to pay dividends. This is because Shareholders have to pay Income Tax on dividends but also because of another reason: buying back the company’s shares reduces the outstanding shares, which are the shares that are still circulating on the market, which in turn increases the per share earnings of the company, which eventually makes the stock price go up.
Example: If the company earns 10 Mio.$ and has 2 Mio. of shares outstanding, it will have an Earning per Share (EPS) of 5 $/Share, ten divided by 2. If we decrease the number of outstanding shares to a million, because let’s say that the company buys a million back, we’ll have an EPS of 10 $/Share, double as much as before. And this happens without even increasing the net earnings. The best part is that this increases the Shareholders’ interest without having them to pay taxes on it until they sell the stock.
Usually Buffett pushes all Board of Directors of the companies he partially owns to always try to buy back their Shares as much as they can instead of increasing the dividends.
So always check the Common Stock Repurchases in the Cash Flow Statement under Cash from financing activities to find out if the company is buying back its shares.
How Buffett finds the right time to buy
So after I gave you this overview of the Cash Flow Statement, and if you watched my previous videos you also know about the other financial Statements like Income Statement and Balance Sheet, we kind of know which are the important factors and numbers to look for before investing in a company.
We managed to define what makes companies great and what a durable competitive advantage is, but we also know that if a company is really so great, it’s going to be hard to buy its shares at a cheap price. Companies with a DCA almost never sell at a bargain price. So when do YOU buy into them? There are 2 particular moments where you should be really active in stock picking and can potentially find great deals:
- In bear markets. This is by far the best way for private investors like us, and one of these moments is the bear market of 2022, with great companies selling at 30-50% the price they were selling 1 year before.
- When the great company does something stupid but reparable, that drives its stock price down. This is also a good moment and it can be a tricky one. Sometimes the company faces a so-called “one time solvable problem”. Something that poisons its reputation in front of the public and causes a sell out that drives the stock price down, but this problem is solvable and we manage to foresee that they will solve it soon. An example is when Samsung a couple of years ago produced some tablets that started exploding in airplanes, I don’t know if you remember about that. Well, that was of course big news and drove the price down, but you could imagine that it’s not something terrible that is going to destroy Samsung in the long term.
Ok and when to stay away from these businesses?
- At the highs of bull markets. For example, 2021 was the peak of a bull market that basically started in 2010 and whoever bought stocks in 2021 is probably down a lot right now.
How Warren Buffet determines it is time to sell
Now let’s ask ourselves another question: when should you sell? Theoretically you never sell a business as long as it maintains its DCA. The simple reason is that through compound interest the longer you hold onto these businesses the better you do. Moreover whenever you sell you will have to pay taxes. Do it many times and you will never get rich.
Still there are times when it might be a good option to sell:
- When you need money to make an investment in an even better company at a better price, which occasionally happens
- When the company looks like it’s losing its DCA (thing about newspapers and television companies after the Internet came along…)
- During bull markets, when the stock market in an insane buying frenzy sends the prices of these fantastic businesses through the ceiling. But if you sell in bull markets, then you should not buy back something else that also sells at a high P/E. Instead, take a break, put your money into US Treasuries and wait for the next bear market.
Ok that was all, I hope you could find some value in this video, and if you did I’d really appreciate it if you subscribed to my channel and hit the like button. In my channel I always share what I learn on the topics of finance, self development and productivity and I’d love to have you on the journey with me. If you haven’t, check out my other videos of this short series about the financial statements and the Durable Competitive Advantage, and I’ll share the links in the description below.
Well, I wish you a great evening and I’ll see you in the next video. Ciao!