Valuing Google Based on 'True' Free Cash Flow

An investor takes the first brave step from beginner to expert when leaving earnings per share [EPS] behind and moving to free cash flow [FCF]. No doubt it’s tough to forego the comfort of the EPS cradle -- where all financial media caress you with information -- for the cold, cruel work of the media-orphaned cash flow statement. But it’s the only path to investing enlightenment (that is, truly knowing your company), grasshopper, and we must follow it.

Unfortunately, investors do not agree how to calculate this key number that goes into all value investing analysis. Fortunately, learning the different factors of free cash flow is fun and builds confidence!

As we wend our way, today using online leader Google (GOOG) as our example, you will gain investing power and end up knowing more about this subject than 99% of investors.

Flow, cash, flow
Let’s start with a simplified nine-month 2007 cash flow statement for Google, taken from the company’s recent results [we always wait for the SEC filings for finalized numbers, but in this example, the press release has to do]:

click to enlarge

What the statement does here is really quite simple. Because the income statement is an accountant’s rendering of company revenues and expenses for tax purposes, there are many items that are accounting fictions – items that increase or reduce free cash flow but aren’t cash themselves. A major one is depreciation and amortization. The cash flow statement takes net income from the income statement and adds back D&A and other non-cash items in the “cash flows from operating activities” section.

Once we have the net cash generated by operations, we need to deduct investments in property, plant and equipment, such as computer equipment to provide services, a new warehouse, or in the case of a software company capitalized software development costs. You find this information in the “cash flows from investing activities” section.

The first nine months of 2007, Google had net cash from operating activities of $4.082 billion (Item A) and cap ex of $1.724 billion (Item B), leaving true FCF of $2.358 billion. With 316 million diluted shares, that’s FCF of $7.46 a share for nine months.

Tax or non-cash benefits, bah!
But wait. The next step beyond true FCF is to subtract items that are not actually cash generated by operations, such as the tax benefit from employee exercise of stock options, or stock-based compensation. While the tax benefit and compensation does produce cash for a company in a roundabout way (lower taxes equals more cash retained, and paying stock rather than cash obviously preserves cash), it is not what any of us really considers to be operating activities.

We want to value Google as a business based on its advertising dollars earned and related online income from operations, not on how successful it is in awarding stock options. If we fail to exclude these non-operational numbers, we have Fake Free Cash Flow.

When we subtract stock-based compensation, Google's FCF number is now lower, or $1.735 billion, and the per share figure is $5.59 a share, or 25% less.

With Google’s enterprise value at about $190 billion as of Oct. 21, the difference between including or excluding the benefit from this non-operational item is that between an EV/FCF multiple of 82 and 111 on the trailing 9 month results. And that’s without the most important effect, which is the difference in intrinsic value you find whether using the former or the later as your base-year FCF in a discounted valuation model. The end results are miles apart.

By the way, on trailing one-year results, Google is fetching about 83 times TFCF, while the measure has grown more than 70% this year.

Comments

[Bill Burnham:]

Not sure why you would back out stock comp from free cash flow if you are trying to get a true sense of the operating cash flow. Stock comp is a theoretical, non-cash charge that is not related to operating performance. If you are trying to get a sense of operating performance you should definitely leave stock comp in the cash flows, not take it out. At the very least if you are going to take it out then you have to back out the tax benefits of it as well to be consistent.

2007 Oct 22 03:50 PM