Share Analysis: Buybacks and Free Cash Flows

by Manshu on February 11, 2013

in Investments

I wrote about 5 ways to generate share investing ideas a few weeks ago, and once you have the initial idea – the next thing is to evaluate how good or bad the company is with respect to its price.

There are several parameters for this, and in this post I’d like to talk about two that I was reminded recently when AOL (American Online) declared its quarterly results.

I’m interested in both Indian and American markets, and AOL is a stock that’s listed on NYSE. The company has two main business segments – it provides dial up internet service and runs popular websites such as TechCrunch and Huffington Post.

This company used to be a lot more relevant a few years ago, and somewhere about a year and a half ago I got the idea to see if this company will be a suitable short candidate (like thousands of other people I’m sure).

Here are my notes from that time (absolutely unedited):

S.No. Question Comment
1 What is the product and is this a good product? AOL has two products – it has content websites like aol.com huffington post and TechCrunch and it is a dialup internet service provider
2 What is the size relative to its peers? It has a market cap of 1.4 billion so not very big
3 Category Short candidate due to declining revenues
4 Conclusion Should DEFINITELY NOT short it yet, but it will become a short candidate in the future. Why you shouldn’t short it now:1. The company has a share buyback program2. It generates free cash flow.Free cash flow has declined from 389.5 mm in the 9 months 2010 to 92.1 mm this year. Keep observing if the free cash flow continues to decline and keep it in the short list.The company has authorized 250 mm buyback program and the market cap is 1.4 bn so they are going to buy back about 20% of their own stock, and then with the free cash flow they can authorize more buybacks as well.
5 List the products & their contribution to bottomline Advertising – which is ads on its websites, and subscription viz. monthly charges for its internet service.

Since the time I wrote down these things, the stock has almost doubled so I feel rather stupid when I read this today. Not only was this not a short candidate, but instead it was a great long candidate!

However, for the purpose this post, I’d like to highlight the two things that I paid attention to at the time, and are worth your time too if you are looking at analyzing stocks.

Free Cash Flow: Free cash flow (FCF) is perhaps one of the most important things to look for in a business. Simply put, it’s the surplus cash with the business. Every business that generates cash needs to put some of it back in its operations to sustain the business. FCF is the cash that’s left after that.

Investopedia has a good definition:

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it’s tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as:

EBIT(1-Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditure

It can also be calculated by taking operating cash flow and subtracting capital expenditures.

Read more:

http://www.investopedia.com/terms/f/freecashflow.asp#ixzz2KSeVPpbl

 

Share Buybacks: Share buybacks are another interesting thing to look out for because a company that’s buying back its shares has a smaller capital base and thus the profits available to each shareholder increase over time if the company makes money at the same rate. It also implies that the company is generating sufficient cash to pay for its operations, pay down debt, and can now reward the shareholders in this way.

These two things are good to look at, but remember that they have to be seen within the whole context of the company and its operating environment, and you can’t rely on just these two factors alone.

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{ 2 comments… read them below or add one }

harineem February 13, 2013 at 3:27 pm

How does one short in an online broker like icicidirect without doing options? Intraday I know but over a longer period how do you do it?

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Manshu February 13, 2013 at 9:12 pm

You can sell a Future but I think the max expiry date is just 3 months away. You can’t borrow shares to short in India.

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