Calculating Free Cash Flow: Should You Include Changes in Working Capital?

by Geoff Gannon

A reader sent me this email:


I have just recently started to use discounted cash flow analysis with owners earnings. You have stated that changes in working capital should be included in owners earnings calculation. However, a lot of value investors on the web seem to think that changes in working capital should not be included…Up until now, I have excluded changes in working capital. But your articles have made me think that I should include it. If you don't mind, please clarify this for me. I just want to use the right data for my discount cash flow analysis.

Geoff, if changes in working capital is included in owners earnings then would the owner's earnings formula simply be: cash from operations - maintenance capex? I sure hope so, because having to exclude working capital is very confusing because not all financial sites list it the same way.

Also, what free financial site has the most accurate cash flow statements? I personally have been using MSN MoneyCentral, but I (am) starting (to notice) that sometimes their figures are different than the company's 10K filing. Any suggestions? 




You should include changes in working capital. So, when I say free cash flow I simply mean “cash flow from operations” less “capital expenditures”. Some people talk about separating growth capital spending from maintenance capital spending (including Warren Buffett). They’re obviously smarter than I am or have access to financial statements I don’t. The statements prepared for outside investors – not management – don’t provide enough detail to separate growth capital spending from maintenance capital spending in more than 90% of the cases. Birner Dental Management Services (BDMS) is a rare exception.

Warren Buffett was explicit on the issue of including working capital in his 1986 letter to shareholders:

If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included…)

I don’t do discounted cash flow calculations. Charlie Munger says Warren Buffett doesn’t either.

A lot of people do discounted cash flow calculations. And a lot of people don’t wear seat belts.  

Discounted cash flow calculations are the most misused tool in investment analysis. I think they’re insanely risky. But, again, most people disagree.

I read the statements at EDGAR. The figures I cite here are always taken from EDGAR and then adjusted as necessary by me.

You can use GuruFocus, Morningstar, or MSN Money for a first glance at the ten year numbers. None of them are accurate enough to replace EDGAR.

Obviously, some companies decrease working capital year after year because sales are permanently decreasing and they are effectively self-liquidating. This is how returns on capital return to normal for many net/nets. They don’t necessarily grow earnings. They cut capital. Competitors exit the industry. Returns on the capital that remains in the industry rise.

You don’t want to assume a decaying business will continue to produce the same level of free cash flow in future years.

Decay – like growth – is usually easier to look at qualitatively rather than quantitatively. So some folks should just ignore all businesses in permanent decay when looking for stocks to buy.

Talk to Geoff About Calculating Free Cash Flow