August 28, 2008 - "The Importance of Free Cash Flow: A case study of WellPoint"
Most investors focus on earnings per share because they think that a company's earnings reflect a company's true performance. This is simply wrong. A company can find many ways to manipulate earnings. Many great investors like Bruce Berkowitz focus on a metric called Free Cash Flow (FCF). It's so important because it signifies the money you can take out of a company without hurting the business. As a shareholder of a company, you are most interested in the cash left in the register after all the expenses are paid. With that money, you can get paid dividends or a company can make acquisitions. It's the only real thing you as an investor have.
How do you calculate FCF? You need to look up a company's balance sheet and read their cash flow statement. I found this information by going to Yahoo! Finance: http://finance.yahoo.com/q/cf?s=WLP. You can find it any major investing website. Free Cash Flow is a company's earnings (Net Income) plus depreciation minus capital expenditures. This formula makes sense. Depreciation is just an accounting term that signifies how much value a factory or machinery has lost in value over the course of the year. The factory is still functional, but is worth less just through general use. Therefore, depreciation is not actaul money lost, but just an accounting manipulation. Since the company didn't actually lose this money, we add it back in to earnings. Capital Expenditures shows how much the company had to spend to replace worn out machinery, factories, buildings, etc. Since replacing this stuff is necessary for a company to maintain it's normal level of production, it makes sense that we subtract that from their earnings. Companies need to spend that money to maintain thier business so they no longer have that cash on hand.
| PERIOD ENDING | 30-Jun-08 | 31-Mar-08 | 31-Dec-07 | 30-Sep-07 | |
| Net Income | 750,500 | 588,100 | 859,100 | 868,000 | |
|
| |||||
| Operating Activities, Cash Flows Provided By or Used In | |||||
| Depreciation | 145,400 | 144,700 | 144,100 | 146,600 | |
| Adjustments To Net Income | 110,100 | 65,700 | 135,900 | 35,600 | |
| Changes In Accounts Receivables | (158,900) | (454,000) | (7,200) | (242,500) | |
| Changes In Liabilities | (725,600) | 802,800 | (694,200) | (25,900) | |
| Changes In Inventories | - | - | - | - | |
| Changes In Other Operating Activities | (10,000) | (113,500) | 666,600 | (248,500) | |
|
| |||||
| Total Cash Flow From Operating Activities | 111,500 | 1,033,800 | 1,104,300 | 533,300 | |
|
| |||||
| Investing Activities, Cash Flows Provided By or Used In | |||||
| Capital Expenditures | (77,000) | (79,000) | (110,500) | (91,400) | |
| Investments | 188,400 | 568,600 | 488,800 | 188,200 | |
| Other Cashflows from Investing Activities | (112,000) | (32,000) | (58,600) | (262,800) | |
|
| |||||
| Total Cash Flows From Investing Activities | (600) | 457,600 | 319,700 | (166,000) | |
|
| |||||
Since we are only half way through the year, we can only calculate how much Free Cash Flow WellPoint has made so far. We add Net Income for June and March: (750,500 + 588,100), add depreciation (145,400 + 144,700), and subtract capital expenditures (77,000 + 79,000). We have a total of $1,472,700. but since all numbers are in thousands of dollars in the table, WellPoint actually has $1,472,700,000 in Free Cash Flow. They have over $1.4 billion in excess cash.
The last step is to divide Free Cash Flow by the total number of shares, which you can also find on any investing website like Yahoo! Finance. WellPoint has 511.33 million shares of stock avaialable to buy. Dividing FCF by the number of shares tells you how much FCF the company has per share. WellPoint through the first half of this year has $2.88 of excess cash in FCF. We can roughly assume that this number will double through the second half of the year. That means WellPoint can generate somewhere between $5.50 -$6.00 in Free Cash Flow.
WellPoint is trading at $52 today. Anytime you can buy a good business for under 10x Free Cash Flow, it's generally a very good buy. WellPoint is trading for 9-10x 2008 FCF. You should make sure the economics fo WellPoint's business is attractive to you, but the stock is certainly not expensive.
To read more about WellPoint, see Bruce Berkowitz's commentary here.
