Naturally, I need a guinea pig. For this exercise in value discovery that's shares in instruments maker Renishaw (RSW), a company much admired by Bearbull. I should add that I chose Renishaw before I crunched the numbers. As I write this, I know that Renishaw's share price, at 1,775p, is 33 per cent below its all-time high, but I've no idea whether or not that will prove good value.
Chiefly, we want to do three things:
■ Explain why cash profits matter more than accounting profits.
■ Define the measure of cash profits that investors should focus on.
■ Show how to put a value on that cash flow figure.
That, if you like, is the groundwork. As we'll discover next week, there is more to valuing a company's shares than can be précised in 700 words. Still, let's start.
Cash profits matter because cash matters. Thus cash profits matter more than the accounting version because the accounting figure - the number that appears in a company’s consolidated income statement - is modified by various non-cash items, some of which make more sense than others. True, accounting profits and cash profits may be a close match, largely depending on where a company lies in its life cycle; and, over the whole cycle, cash profits and accounting profits should equalise anyway. But since it takes no great effort to concentrate on cash profits, then it's best to do that from the start.
The most important measure of cash profits for equity investors is so-called 'free cash flow' - free, because it comes without encumbrances. It's the cash left over for the owners of a company after the costs of running and developing the business have been paid and the prior claims - chiefly from the owners of debt and from the taxman - have been met. In other words, it's the cash profit that belongs to shareholders however much of it is distributed to them.
The table shows how accounting profits were turned into free cash for Renishaw's latest full year, to end-August 2015. Depreciation and amortisation, which is the charge for using up the group's fixed assets, is the major non-cash charge against accounting profits and is written back. Meanwhile, its cash flow corollary - capital spending on fixed assets - is a cash cost that's excluded from the income statement but comes into the reckoning here. Additionally, changes in the working capital needed to run the group, which could be a plus or a minus as cash is sucked up or disgorged, hits cash flow, as do the taxes paid on profits, which can be quite different from the taxes charged in the income statement.
Where free cash comes from
| Renishaw, year to end August 2015 | £m |
|---|---|
| Operating profit | 142.5 |
| Depreciation & amortisation | 28.1 |
| Capital spending | -62.6 |
| Working capital | -16.7 |
| Corporation tax | -16.4 |
| 'Other' | -5.2 |
| Free cash | 69.7 |
| Free cash per share (p) | 96 |
There are always other bits and bobs - items such as dividends received or accounting losses on disposals charged - and these are rounded up in the column for 'other'. It's also the case that few companies specify a line for free cash in their cash flow statement. In addition, many companies - Renishaw included - don't use a nice clear top-down approach to itemising cash flow, starting from operating profits and working through the costs and write-backs until they're left with free cash. Instead, they work from the bottom of the income statement upwards, starting from net profits and working back to various levels of cash flow.
That said, however a company shows its cash flow, it's not a work of genius to find the amount of free cash. If that's the measure of cash profits, then how do we put a value on it? As we will see next week, by doing more work. But the basic idea is to value the free cash as an annuity, a stream of income that will keep going forever. You pay the price upfront and in return you get the annuity every year - £69.7m if you own all of Renishaw’s equity, or 96p per share. How much that's worth depends chiefly on the rate of return you want. But other factors intrude; such as whether cash flow for 2014-15 is a representative figure and, if not, then how do we find one? What about growth? Companies are supposed to grow, so how do we factor that into the mix. And should we completely abandon that dear old metric, the price/earnings ratio? Maybe PE ratios still have a use, but that's for the week after next.
