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Given the rise in financial valuations the past 7 weeks without any obvious increase in economic strength also present in the “Main Street” economy, detailed security analysis is now taking on increased gravity. This is especially so with another earnings “season” upon us, and with it, an avalanche of references to cash flow and free cash flow. If only investors and financial reporters had greater clarity regarding cash flow analysis, stock volatility would be much reduced and investors’ financial results improved.

And as pundits point to the past 18 months' large increase in free cash flow (which is accurate), they most often fail to make adjustments to those reported operating results. Now one may say, so what if normalized free cash flows really grew by 13% instead of 15% these past 4 quarters? After all, look at the comeback in my portfolio and for the equity markets.

But these adjustments matter - big time. They tell the real story, with greater precision, of the free cash flows an entity is really producing. And, as we painfully re-learn during every period of economic and industry weakness, stocks often fall on the order of 30% or more when investors sense or are exposed to a change in realized cash flows. So don’t be so impressed with the S&P’s 6% return this year, and mere 1.6% return over the past 5 years, to say nothing of the negative return over the past decade.

When you hear the current melodic whistling and the voices of great success regarding a particular investment, one might dutifully ask: What would be the change to that investment’s cash flow if the economy sank anew, or if the prices of their inputs rose by 40%, or that important country or state in which they operate posed new restrictions on their business? Or their largest client lost a large lawsuit? Or they lost certain tax credits? These must all be accounted for in the cost of equity capital, which help set valuation levels, but for which investors are failing to account, in their cash flow and credit models. Given the slowness of the macro climate, should not investors be paying attention to the certainty of the prospective free cash flows, and is this not too part of cash flow based security analysis? Show me where this is being contained in the reports you are reading and how it is being quantified in the valuation process.

I must respond to a recent article published in Forbes.com, with similar stories appearing elsewhere, that insinuate operating and free cash flow are better indicators than net income---while the general premise is true, it might be hard to convince stockholders in those financial and other firms during 2006 and 2007 which either went belly up or whose stocks fell to the low single digits while showing record to near-record cash flows. The reason for the apparent incongruity is analysts failed to adjust stated cash flow from operations for both normality in the working capital and other balance sheet items as well as other spending listed elsewhere in the statement of cash flows. It is of course typical of firms in distress or in need of cash to tap their balance sheet, not external capital, of which it may not have access.

In truth, cash flow from operating activities must be adjusted with each passing quarter to gain the advantage over investors who merely accept the published results verbatim.

Free cash flow, now a mainstream metric (believe me, it wasn’t 30+ years ago) must be adjusted as well, given that analysts, including those working for rating agencies and sell-side brokerage firms, begin their definition of this most important benchmark with unadjusted (or sometime only lightly adjusted) cash flow from operations. In this very brief article I will not address the important adjustments to discretionary and other areas that need to be looked upon as possible incremental free cash flows.

To not have you think I am cherry picking examples, which is common for those wishing to prove any point of view, I looked at those 10Q’s filed this past Friday. However, I can prove my point with any day’s filings. In that 10Q for Home Federal Bancorp (NASDAQ:HOME), I would adjust cash flow from operations to account for some of their deferred tax benefits, ESOP shares, gains on sale of securities and other noncurrent assets and liabilities. I would adjust for Syms Inc’s (SYMS) other long-term liabilities, and for Pepsi (NYSE:PEP), I would adjust for merger and integrations costs, the equity in the bottling company and a reversal of tax liabilities. All of these adjustments impact free cash flows.

In my book, to be released next week (after all, it took just a few decades to write), I show specifically how these adjustments are to be made. They include the important adjustments to working capital items, misclassifications, leases, other non-current assets, extraordinary items, etc. I also provide examples of firms which were in distress where net income was a more reliable indicator than cash flow.

If such adjustments are not made, then you are not a cash flow analyst, regardless of how many times you refer to the term in your writings.

And this says nothing of the adjustments to total debt such as underfunded pension, unhedged derivative contracts, and upcoming payments on lawsuits or other commitments outside the course of normal business activities. The text enters into these matters as should the security analysts and reporters who mimic what they are being told or are reading.

The only absolute in the short run is nothing is absolute, even cash flow, for that too may be fleeting, but whose certainly and stability should be reflected through an appropriate cost of equity capital.

To take cash flow from operating activities or free cash flow, as reported, without adjustments will often send investors scurrying in the wrong direction.

Disclosure: No positions

Source: The Importance of Understanding Cash Flow