Saturday, December 27, 2008

Enterprise Value and Free Cash Flow II

This is a continuation of the last post talking about EV and FCF.

A company generates cashflow based on its day-to-day operations. Eg. SIA selling air tickets with fuel surcharges 2x actual ticket prices. The millions of ticket sales generate cash. Of course SIA needs to pay the pilots, the stewardesses, the fuel, landing charges etc. After netting the expenses, it should still have cash left. Some co.s don't, if you own some of these, good luck! Anyways, this no. is called Cashflow from Operations.

Next, SIA needs to spend some of this cashflow on equipment to maintain its operations. Like buying new planes, pilot training programs, etc. This no. is called Capex which is the short-form for capital expenditure.

When you deduct Capex from Cashflow from Operations, you get a no. called the Free Cash Flow. Basically, that's what's left that can be distributed to shareholders or to pay down debt. If the company has no debt, it's basically money that can be paid to the shareholders.

Over the course of many many years (like 10 yrs or more), a good co. will generate significant Free Cash Flow and has the capacity to even grow this amt over time. Now finally, things are getting interesting right? These are co.s that value investors look out for. Usually, I would look at that past 10-15yrs of FCF and take an average amt to use that to calculate EV/FCF. I am assuming that the company can generate this average FCF in the future for many many years.

Let's look at SIA. Over the past 10 years, SIA has 5 yrs of positive FCF and 5 yrs of negative FCF. Cumulatively, it generated a miserable S$175mn of FCF. Our ministers' salaries over 10 years would have generated as much. This is what the most profitable airline in the world can manage. Moral of the story: Don't ever buy an airline!

Combining the two things, you get EV/FCF which is just a measure of the cheapness of the company. The lower the better, like the PE ratio. If this ratio gives 5x, it means that theoretically, you get back your money in 5 yrs. Usually it doesn't get cheaper than that. EV/FCF ranges from 5-15x usually.

Again, back to SIA, the EV is S$8.8bn based on current stock price of S$11+. Calculating EV/FCF give 8800/175 = 50.3x. If you buy SIA today, the free cashflow generated should be able to cover your purchase in about 50 yrs. That's great isn't it? Maybe just in time to cash out and pay for the funeral expenses!

Sunday, December 21, 2008

Enterprise Value and Free Cash Flow I

Once upon a time, we talked about a radical ratio called EV/EBITDA which was invented and nearly won the Nobel Prize in Most Innovative Financial Ratio ever invented. Well someone topped that and invented EV/FCF which is Enterprise Value over Free Cash Flow.

What's so great about EV and its alphapetical soup of acroynms? Ok, let's define the terms first.

EV = Market cap + Net Interest bearing debt
FCF = Cashflow from Operations - Capex

For the uninitiated, pls follow the hyperlinks and read what is Market Cap, Cashflow from Operations etc. I will explain EV and FCF.

EV stands for Elise Vuitton, cousin of Louis Vuitton who recently came out with her own luxury brand of leather bags to grab share from the legendary LV.

Oops, wrong number. Ok, here's the real deal.

EV is sort of the theoretical takeover price of a company. In the event of a buyout, an acquirer would need to pay the market price (or market cap) to the existing shareholders. However he would also have to take on the company's debt, but pocket its cash (hence looking at NET interest bearing debt is impt). If a company has no debt and some cash, then EV is less than market cap and the acquirer will be getting a bargain!

Actually in today's market, some co.s are trading below net cash! This means that EV is actually negative. You get paid to buyout some co.s listed on SGX! It goes to show how irrational things can get when markets go crazy. However, as quoted by the great Keynes: markets can stay crazy longer than you can stay liquid. Well usually also longer than you can stay patient lah. Nevertheless, having said all that, it goes to show that markets today are really cheap. This is the Great Singapore Clearance Sale value investors have been waiting for! But wait tomorrow things can get cheaper though.

Anyways, that's EV. In the next post, we shall explore Free Cash Flow or FCF.

Saturday, December 13, 2008

Losers' Game

This is the title of an essay and a book by one of the most prominent minds in finance. Just google it to read the original text. I will provide a brief summary here.

In this world, there are two types of games being played. Winners' games and Losers' games. In winner's games, the winner wins through his own actions. In loser's games, the winner wins through his opponents actions. The usual example to illustrate this is tennis. There are actually two type of tennis being played in the world, as observed by some hotshot coach. Amateur tennis and professional tennis.

Professional tennis is a winner's game. Federer wins by delivering the ace that nobody can counter. Or that smash, or whatever. The winner wins through his own actions. In amateur tennis, usually Ah Lian wins by doing nothing. Why? Bcos Ah Beng tries to deliver the ace or that smash to Ah Lian but the ball goes out-of-bounds. Ah Lian wins bcos Ah Beng keeps doing silly things when he is not up to it.

According to the original author: professional golf is also a loser's game. The winner wins by playing it right and let their opponents hit bunker or sand or whatever. But Tiger plays it like a winner's game. Hit bunker but comes back spectacularly and ends with a birdie. That's why everybody loves him!

And finally, the core of this post. What is the biggest losers' game in town? Yes, that's investing. Investing is a loser's game. How do you beat the market?

First, you cannot make silly mistakes. In all loser's games this is the first criteria. You cannot try to be like Federer. Play it safe. do the boring parry. In investing it means don't buy on rumour, don't try to do that punt bcos it dropped 50% in one week, next Monday sure rebound one! Or die die do 2 trades every month to meet that stupid broker quota to save a few dollars on overseas stock deposited at the broker. These are like Ah Beng trying to be Federer. Well unless you ARE like Federer, ie you can trade damn well and earn these quick bucks with 99% success rate, like legendary traders Baruch, Livermore. If so, then ermmm why are you reading this post, you should already be a Big Swinging Dick trading big bucks and writing your own blog! Well, I'm flattered anyways.

Second, you only beat the market when it makes mistakes. Alas, the market don't make mistakes. The market is always right, remember? Well the market is right until the time horizon where all the participants can see what's going on. E.g. the market fell 50% this year as all the participants can only see the severe recession coming in 2009. Nobody knows what's gonna happen after that. If we don't go into the 1930 Great Depression scenario, global economy will bounce back in 2010, 2011, 2012, who knows. But when it does, solid co.s like Coca Cola, Canon, LVMH will continue to grow. So that's one way to beat the market. Sometimes, the market does some obvious mistakes. Like mkt cap of Citigroup going lower than the combined mkt cap of Sg 3 banks. Unless C is going under, this should not happen. And after Lehman went down and create this mess, will the authorities let Citi go down? So in such rare occasion, you can beat the market. But by and large, market don't give you that many chances.

So the conclusion: don't trade, play it safe, and according to the author, who is a strong supporter of indexing, buy indices. Buy the STI ETF, or the S&P500 or the Hang Seng. It's futile to beat the market, so just earn market return.

Saturday, December 06, 2008

Fallacy of scruntinizing ratios for the past few years

Financial statements are very essential in fundamental analysis and value investing. To value investors, it's like soldier's M16, accountant's Excel, taxi driver's taxi, you get the idea. From the statements, we calculate the all important ratios. Basically it's one number divided by another and that's supposed to give you insights into the company's business operations, its edge or whatever. Something like adding apple juice to aloe vera and drinking the new juice will actually make you thin!

Actually around like 2% of the time, looking at ratios actually help a bit. The problem is we always only look at last yr's ratios. Or maybe some diligent analyst will look at ratios for the past 5 yrs. Not bad huh. 5 yrs quite long right? Presidential term only 4yrs. Alas, do they know on average how long is one economic cycle from peak to peak or trough to trough?

Well, its seven years on average. The recent one, 2001 to now and still going. The one before 1997 to 2001. 4 yrs, well sometimes it's shorter than average, obviously. So by looking at 5 yrs of ratios like ROE, operating margin, debt to equity ratio, can you really tell if the co. is really good? Esp if you are looking at 2002-2007 and the ratios just keep improving every yr? Like those we see in annual reports. Sooooo impressive. This co. is really something, we tell ourselves.

Our hero, Warren Buffett some yrs back started to ask co. owners to come forward to him if they intend to sell their stake to Berkshire. One of his criteria: GROWING earnings for the past 15-20 years. So seven years still quite amateur actually. Of course, most Sg co.s were not around 20 years ago. So we just have to make do with seven years lor.

So, that's the moral of the story: a co. with improving ratios for the past few years is not necessary a capable one. Rising tide lifts all boats. Keep the economic cycle in mind when looking at ratios for the past few years.