Last week, I attended an event hosted by the New York Society of Security Analysts in midtown Manhattan. The evening centered on George C. Christy and his book Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks. Mr. Christy has over thirty years of professional financial experience including time at GE Capital.
Mr. Christy began by stating the well known belief that most of the “accounting fog” in modern financial statements comes from accrual accounting. He referenced Georgia Tech accounting professor Charles Mulford’s book Creative Cash Flow Reporting for further demonstration (note that Mulford also endorsed Christy’s book, so there’s a bit of cross-promotional bias there). Public companies are managed for earnings per share rather than cash generated for shareholders. While these are solid points, he made a very bold claim by stating that “only 10-20% of CEOs can define free cash flow.” Considering that 39% of S&P 500 CEOs have MBAs (and, according to Spencer Stuart, 22% of the S&P 500 CEOs have MBAs from Harvard), that claim may be a bit exaggerated unless introductory accounting and finance classes are not taught anywhere else but Cambridge. It was much easier to believe his statement that, without the help of their auditors, “before (Sarbanes-Oxley), many small microcap companies could not generate a cash flow statement.” Much earlier in his career, Mr. Christy worked at a microcap investor relations firm and has particular expertise on that subject.
My main takeaway from the evening is the emphasis on free cash flow deployment and its ability to add to (or subtract from) shareholder value. “Companies will be able to differentiate themselves through efficient use of capital,” Mr. Christy noted. This is accomplished by using capital either for acquisitions, dividends, as well as debt and share repurchases.
Mr. Christy’s approach is novel and quite elegant, but, like all valuation methodologies, is not without criticism. Most notably is the use of current stock price as a starting point rather than a pure bottom up approach of determining equity value such as a discounted cash flow model. Plain use of dividend yield, which one of the attendees brought up in the Q&A session, is also dependent on taxation policies, payout ratio and shareholder preference for dividends. For example, if an investor buys a company for a great management team who makes excellent use of capital, retentions or buybacks are preferred. Though this is easily solved with a dividend reinvestment plan (DRIP), the argument makes adding the dividend yield here redundant and overestimates expected return. Finally, there was very little specific mention of how to estimate value added due to acquisitions. This, however, can be a highly strategic and qualitative subject that is difficult to quantify even for the most sophisticated industry analysts.