Few questions about financial statement analysis

[mattee2264]

 

  1. With Brexit a lot of UK companies have an earnings tailwind as a lot of their revenues are from overseas while costs are mostly local. While management usually provide some colour on what revenue growth is on a constant currency as opposed to a reported basis I am not quite sure how to take this all into account when trying to arrive at some notion of normal earnings power. Is the best way to focus more on five year revenue/earnings past averages which will average out FX fluctuations or to use management guidance to try and get some sense of constant currency revenues and then proceed with margin assumptions etc to work your way down to earnings?

 

2. Some of the companies I've been looking at recently have been involved in various restructuring efforts, acquisitions over the years as well as selling off businesses and discontinuing operations. As a response to this they report "headline" numbers in addition to statutory numbers as well as splitting PAT between continuing and discountinuing operations. The issue is whether such charges are really one-off or likely to continue to feature going forward as competitive pressures and the greater of economic and techonological change continue to force these companies to reposition themselves, buy and sell operations, etc etc. Again other than taking a past average of such charges or being conservative and accepting the charges as part of current year earnings I cannot think of a satisfactory way to make this judgement call as I do not want to rely on an ability to have superior business insights especially concerning the future to make money.

 

3. When analyzing free cash flow for businesses what is the best way to take working capital needs into account? Simple formulas for FCF take cash from operations and deduct capex or an estimate of maintenance capex. But for some businesses a lot of the resulting cash is not really free in the sense that it is required to meet working capital needs of the ongoing business. But the change in working capital number can be very volatile year to year due to timing differences etc so I am finding it difficult to get a normalized kind of number to deduct in calculating FCF.

 

Thanks

 

[KJP]

 

3. When analyzing free cash flow for businesses what is the best way to take working capital needs into account? Simple formulas for FCF take cash from operations and deduct capex or an estimate of maintenance capex. But for some businesses a lot of the resulting cash is not really free in the sense that it is required to meet working capital needs of the ongoing business. But the change in working capital number can be very volatile year to year due to timing differences etc so I am finding it difficult to get a normalized kind of number to deduct in calculating FCF.

 

 

Under GAAP, changes in working capital are already included in operating cash flow, so historical changes in working capital are already included in the reported cash flows.

 

To project normalized future working capital requirements, you may be able to look at historical working capital needs as a percentage of revenue, e.g., average inventory over the year has historically averaged  X% of annual revenue, average accounts receivable over the year has historically averaged Y% of revenue, and so forth.  If those ratios are relatively stable over time, they can be a useful starting point for understanding likely working capital needs at various future revenue growth levels.

[Travis Wiedower]

2. These are almost always judgment calls. If the company has made one acquisition in the past fifteen years, I generally ignore it. If they've made six acquisitions in the past ten years, I'll probably assume acquisitions are a normal part of their business so I average those costs of acquisitions over a period of time (as a percent of revenue) and assume that percent going forward. It's similar with restructuring. If they've had one or two restructuring charges in the past decade that seem legit, I probably ignore those expenses. If they have "one-time" expenses every year or every other year, I assume those are a normal part of the business. It's all about trying to figure out what the normal operating business generates in terms of FCF.

 

3. Like KJP (and similar to my answer above), I deduct D&A and then add back in a normalized capex number. If it's a more mature business, I look at capex margin over the past 5-10 years and use that going forward. If the business is growing quickly (thus their capex margin is probably decreasing over time) then I'll probably assume that capex margin slowly comes down over time. Every company and situation is different and judgment calls are required. That's what makes investing fun :)

[Dynamic]

 

  1. With Brexit a lot of UK companies have an earnings tailwind as a lot of their revenues are from overseas while costs are mostly local. While management usually provide some colour on what revenue growth is on a constant currency as opposed to a reported basis I am not quite sure how to take this all into account when trying to arrive at some notion of normal earnings power. Is the best way to focus more on five year revenue/earnings past averages which will average out FX fluctuations or to use management guidance to try and get some sense of constant currency revenues and then proceed with margin assumptions etc to work your way down to earnings?

 

I have noticed that in some I follow (though I no longer own any UK shares), such as Halma plc with a ton of non UK subsidiaries and sales. I sold at 808p in Feb 2016 and it has rocketed to 1281p now. Lucky for me I was fully USD invested when Brexit came and the pound plummeted giving me 30% boost during 2016 slightly sooner than that boost hit Halma and I bought cheaply and traded up my portfolio's intrinsic value significantly. Since then the USD has weakened, providing a 10% headwind so I only beat the FTSE100 Total Return Index by just over 2% little last year.

 

When analyzing my annual portfolio returns in both my native GBP and USD I typically look up USDGBP historical figures somewhere like Yahoo Finance: https://finance.yahoo.com/quote/GBPUSD%3DX/chart?p=GBPUSD%3DX where you can change the time scale and look up the historical data by hovering the mouse over the chart. It usually pops up with Open Low High and Close figures for the day in question, so I put the appropriate one in a spreadsheet and adjust the figures.

 

That way I can compare my returns net of new cash converted to USD against the S&P500TR Total Return Index (a good benchmark as I mostly invest in the US at present) and my returns converted to GBP against FTSE100TRI Total Return Index or FT All Share price index and evaluate my portfolio's outperformance and annualised returns.

 

If you take the date of the financial statements, or take an average over the accounting period, you should be able to make some adjustments to the financials in a similar fashion to convert into a currency that has been more stable over the last few years. USD would probably be OK, with no more than about a 10% move in 2017 against most currencies and no major crisis. Brexit and before that the Euro problems with Greek debt etc caused some more major currency swings.

 

I guess the way I'd lay it out on a spreadsheet is to use the rows for various financial metrics you want to analyze, with column 1 being the name of each metric, row by row.

 

The columns would be by date, covering a number of periods over the first set of columns, perhaps 5 or 10 columns for the figures in the native currency. I might shade the fill color of these columns so they are clearly separate from the next set. I'd then have the same number of columns to the right (perhaps the rightmost columns) used for the exchange rate to USD on each of these dates (or a typical exchange rate over the period covered by each financial report) in a different fill color. Perhaps inserting on the left or in between the native currency figures and the exchange rates I'd also insert the same number of columns to show each financial figure converted to USD by multiplying by the exchange rate (or dividing by the inverse exchange rate) using the appropriate exchange rate for the time period in question.

 

You could also refine this as you wish, for example, taking a weighted average of various exchange rates according to the major currencies the company trades in.

 

A similar approach can be used to adjust figures to account for heavy stock buyback programs over time or to adjust certain metrics across a major discontinuity in taxation (e.g. the US tax cut recently implemented) if you want to tease out trends in underlying earning power and not count tax break effects as if they're underlying growth.

 

Once you've set up such a spreadsheet you could probably plug in the numbers for various stocks quite easily and have the figures normalised as you see fit.