Contents - Index

Concept 1:  Economic Dividends
©2009 OS Financial Trading System


First we start with the concept of Free Cash Flows (to the firm) and then we will break this down into free cash flow to equity so we can value the firm's stock.
Estimating Free Cash Flows from a 10-K Statement Filed with the SEC
It is easy to calculate the Free Cash Flow from information filed with the SEC in the 10-Q and 10-K reports.  In their 2008 10-K annual report IBM provided some selected discussion of free cash flows followed by a table comparing across years:
"From the perspective of how management views cash flow, in 2008, free cash flow was $14.3 billion, an increase of $1.9 billion compared to 2007. This cash performance was driven primarily by the growth in net income from continuing operations, controls on capital spending and lower retirement-related funding year over year.
Over the past five years, the company generated over $55 billion in free cash flow available for investment and distribution to shareholders.  During that period, the company invested $14.3 billion in strategic acquisitions and returned over $61 billion to shareholders through dividends and share repurchases. The amount of prospective returns to shareholders in the form of dividends and share repurchases will vary based upon several factors including each year's operating results, capital expenditure requirements, research and development and acquisitions, as well as the factors discussed on page 47."

Cash Flow:



In the above IBM has applied the definition provided earlier for free cash flow. 
Free Cash Flow = Cash Flow from Operations - Capital Expenditures (CAPEX)    1)
Free Cash Flow = 14.3 billion
Tip:  In the above example CAPEX is taken directly from the accounting statements.  In practice this should be viewed as a first pass because the analyst is attempting to assess and understand future CAPEX behavior.  That is, what are the drivers of CAPEX?  This may result in the average CAPEX over the last 3 or 5-years providing a better estimate than the most recent CAPEX number.  In addition, further adjustments may be required that arise from your understanding of the firm's investment decision.  This can lead to additional sources of CAPEX that are not included in the above line item, "Capital expenditures, net" but nether-the-less impact upon your assessment of free cash flows.
Using the latest Data:  
In this section we will re-calculate Free Cash Flow using the TTM (Trailing Twelve Month Data) for IBM.  The following source of data is from the MSN investor site but you should always check the source documents from the SEC web site which are the 10-Q and 10-K reports that contain the financial statements including footnotes.


We construct the TTM data from the quarterly financial cash flow statements (source above MSN Investor).  To construct the TTM it is first noted what the calendar time covered by each column above is.  Given the reporting quirks we construct the TTM data by summing the first column (6-months up to June 30, 2009) with the difference between column 3 - column 5 (covers the final 6-months of 2008).
Cash flow from Operations (TTM) = 9,128 + (18,812 - 8,452) = 19,488
Capital Expenditure:  1623 + (4887 - 2380) = 4,130
TTM Free Cash Flows = $15,358
That is, IBM has improved it's FCF over the "TTM period of time" when compared to IBM's 2008 10-K.
Accrual Accounting Adjustments to Capital Expenditure
Under US GAAP each firm must disclose certain items in their change to Stockholders Equity section that may not flow through the regular income statement.  These additional items flow in the concept of "Comprehensive Income."  If these items are large and re-occurring then this should be accounted for as an additional adjustment to the Cash Flows from Operations.  For example for the case of IBM inspection of the 10-K reveals the following:
If you look closely at the changes in the Shareholders' Equity statement in IBM's 2008 10-K reports there is a significant line item ($18,431) that largely arises from net changes in retirement benefit plans ($14,856) and Foreign currency translation adjustments ($3,552).


Looking at the last two years the major components of Other Comprehensive Income are $5487 in 2007 and ($18,431) in 2008.  If we take the average of these two figures we get ($6472).  Averaging over time this is driven primarily by pension expenses which are re-occur over the normal course of business.  These expenditures represent the human capital component of Capital Expenditure.  As a result,  
Adjusting for this has a significant impact upon the FCFE for IBM (billions):
TTM FCF = (15.358 - 6.472) = $8.886 billion


FCF per share = (15.358 - 6.472)/1.31 = $6.783
We next turn our attention to the measure that is relevant for valuing a stock - this is FCFE.

Free Cash Flow to Equity (FCFE)
  
In this current exercise we are really only interested in assessing the intrinsic value of IBM stock not the company as a whole.  As a result, we next make adjustments for the fact that IBM's assets are funded using both debt and equity.  Thus we need to make additional adjustments to take into account that some of the Capital Expenditure (CAPEX) is funded by debt-holders.  Again as a first pass we will make a simplifying assumption.

Adjusting a Stock's CAPEX:   
Suppose the firm's financing decision includes some "target debt ratio."  That is, if the debt ratio remains approximately constant over time then the simplest adjustment is the following:
Free Cash Flow to Equity = Free Cash Flow + Capital Expenditures * (Debt Ratio)     2) 
Notice by substituting in equation 1) above into the "Free Cash Flow" in equation 2) this is equivalent to:
Free Cash Flow Equity = Cash Flow from Operations - (1- Debt Ratio)* Capital Expenditures (CAPEX)                                                                                                                          3)
This method adjusts capital expenditures for that part which is permanently financed by debt holders if debt ratios are relatively stable over time (i.e., debt is rolled over).
Note:  The above heuristic does not apply to a financial institution for which the issue of debt is part of their investment as opposed to financing decision.  For example, the above heuristic does not apply to a bank.
We now turn to applying this discussion to calculate the FCFE number for IBM.
Adjustments to CAPEX for the Financing Decision
The difference between FCF and FCFE is to adjust for the fact that debt-holders fund part of the CAPEX.  We can estimate what this adjustment is from estimating what proportion of the firm's assets are funded by debt.  To do this we will consider one additional ratio called the Debt Ratio:
Debt to Total Assets (D/A)
As a first pass it can be assumed that this is the proportion of CAPEX funded by debt-holders is measured by the Debt Ratio
Example:  Working from the 2009 latest quarterly balance sheet:


Source MSN Investor
Recall TTM FCF = (15.358 - 6.472) = $8.886 billion
Adjusted CAPEX
Capital Expenditure:  1623 + (4887 - 2380) + 6,472 = 4,130 + 6,472 = 10,602
The Debt to Total Assets Ratio (i.e., Debt Ratio) = (20,868 + 0.0 + 8,504)/103,652 = 0.28
FCFE = FCF + Debt Ratio*Adjusted CAPEX =8,886 + 10,602*0.28 = 11,854.56 billion because recall that FCFE is higher than FCF for a firm financed by both debt and equity.

Example:  Cautionary Remark: 
Care must be taken when applying this heuristic to a highly leveraged firm.  For example, suppose leverage (Debt to Total Assets is around 90%.  Under this heuristic virtually all of the CAPEX would be added back!  As a result, the Debt ratio actually applied to the CAPEX adjustment should be reduced to be more conservative to allow for the fact that the high D/E is expected to mean revert to some lower long term average.  In addition, conservative adjustments also provide insights into the scenario of what if credit suddenly dries up and a firm is no longer able to permanently finance a portion of it's CAPEX via debt? 
Current Summary:
To date we have estimated the FCFE for IBM.  This is our estimate of the current "economic dividend" that IBM could pay during a period and existing shareholders would be as well off at the end of the period as they were at the beginning of the period.  
To assess intrinsic value we need to forecast what the future FCFE is likely to be.  We turn to this task next.  In doing so it is convenient to work on a per share basis so we will divide FCFE by the average number of shares outstanding.


Working with the latest quarterly Balance Sheet the shares outstanding for IBM is 1.31 billion.

FCFE per share = 11,854.56/1.31 = $9.049 per share