Stock Investment

1. Stock Evaluation Introduction
2. Earnings Based
3. Revenues Based
4. Cash Flow Based
5. Equity Based
6. Yield Based
7. Member Based
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Stock Evaluation - Cash Flow Based

Despite the fact that most individual investors are completely ignorant of cash flow, it is probably the most common measurement for valuing public and private companies used by investment bankers. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA). (Cash flow in this context should not be confused with Free Cash Flow, which is an important metric to

investors.)

Why look at earnings before interest, taxes, depreciation and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. For instance, CYBEROPTICS (Nasdaq: CYBE) enjoyed a 15% tax rate in 1996, but in 1997 that rate will more than double. This situation overstates CyberOptics' current earnings and understates its forward earnings, masking the company's real operating situation. Thus, a canny analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits.

As for depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. Amortization normally comes in when a company acquires another company at a premium to its shareholder's equity -- a number that it account for on its balance sheet as goodwill and is forced to amortize over a set period of time, according to generally accepted accounting principles (GAAP). When looking at a company's operating cash flow, it makes sense to toss aside accounting conventions that might mask cash strength.

When and How to Use Cash Flow
Cash flow is most commonly used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. Cable TV companies like TIME-WARNER (NYSE: TWX) and TELECOMMUNICATIONS INC. (Nasdaq: TCOMA) have reported negative earnings for years due to the huge capital expense of building their cable networks, even though their cash flow has actually grown. This is because huge depreciation and amortization charges have masked their ability to generate cash. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition, thus it makes sense for investors to use it as well.

The most common valuation application of EBITDA, the discounted cash flow, is a rather complicated spreadsheet exercise that defies simple explanation. Economic Value Added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just eat it up. The most straightforward way for an individual investor to use cash flow is to understand how cash flow multiples work.

In a private or public market acquisition, the price-to-cash flow multiple is normally in the 6.0 to 7.0 range. When this multiple reaches the 8.0 to 9.0 range, the acquisition is normally considered to be expensive. Some counsel selling companies when their cash flow multiple extends beyond 10.0. In a leveraged buyout (LBO), the buyer normally tries not to pay more than 5.0 times cash flow because so much of the acquisition is funded by debt. A LBO also looks to pay back all the cash used for the buyout within six years, have an EBITDA of 2.0 or more times the interest payments, and have total debt of only 4.5 to 5.0 times the EBITDA.

Investors interested in going to the next level with EBITDA and looking at discounted cash flow or EVA are encouraged to check out the bookstore or the library. Since companies making acquisitions use these methods, it makes sense for investors to familiarize themselves with the logic behind them as this might enable a Foolish investor to spot a bargain before someone else.

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