Count Acquisitions in Free Cash Flow

[SlowAppreciation]

Wondering if most here reduce operating cash flow by any acquisition-related costs when calculating free cash flow. For serial acquirers, I think it's apt, but am on the fence when a company maybe makes a few occasional acquisitions. Curious as to hear other's thoughts on this.

[jawn619]

Wondering if most here reduce operating cash flow by any acquisition-related costs when calculating free cash flow. For serial acquirers, I think it's apt, but am on the fence when a company maybe makes a few occasional acquisitions. Curious as to hear other's thoughts on this.

 

Depends on how you want to use free cash flow. If you put a multiple on it, you are doing a shortcut for a DCF, which means you shouldn't include it unless you think it will be an ongoing expense.

[SlowAppreciation]

I'm not one to take shortcuts...

[jawn619]

I'm not one to take shortcuts...

 

Sorry I didn't mean to imply anything about whether or not you take shortcuts. I think your question was regarding acquisition costs and how they affect free cash flow. Let me give an example to illustrate what I'm talking about

 

Let's say a company's FCF is $8M this year but they incurred $2M of acquisition related costs. Now you think the company is worth 10x FCF, should you put a multiple on $8M or $10M? I would say put it on the 10 because when you put a multiple on something, you are doing a DCF in disguise. Meaning you should put it on the 10 unless you think that $2M of costs is going to repeat every year. 

 

As for whether or not to reduce OCF for acquisition costs, you shouldn't because those costs are already taken out in calculation of net income.

 

 

[SlowAppreciation]

No sorry, I knew that's not what you were implying! What I meant by it was that since I generally don't use multiples, I guess I would probably try factoring in any future acquisitions into a model if I were to do a DCF (though I don't rely on them too much).

[SlowAppreciation]

I'm not one to take shortcuts...

As for whether or not to reduce OCF for acquisition costs, you shouldn't because those costs are already taken out in calculation of net income.

 

Maybe I'm misunderstanding this part. Do you mean once the acquirer consolidates the acquiree's operating business? Because as far as I know, there's no hit to income for the cost of the acquisition (save for some restricting charges or the like). It's mostly the balance sheet which is affected, and then costs are capitalized in future periods.

[jawn619]

I'm not one to take shortcuts...

As for whether or not to reduce OCF for acquisition costs, you shouldn't because those costs are already taken out in calculation of net income.

 

Maybe I'm misunderstanding this part. Do you mean once the acquirer consolidates the acquiree's operating business? Because as far as I know, there's no hit to income for the cost of the acquisition (save for some restricting charges or the like). It's mostly the balance sheet which is affected, and then costs are capitalized in future periods.

 

What do you mean by acquisition related costs? If you mean hiring an investment banker, doing due diligence, and costs integrating an acquired company, it does hit net income via SG&A.

[SlowAppreciation]

I'm not one to take shortcuts...

As for whether or not to reduce OCF for acquisition costs, you shouldn't because those costs are already taken out in calculation of net income.

 

Maybe I'm misunderstanding this part. Do you mean once the acquirer consolidates the acquiree's operating business? Because as far as I know, there's no hit to income for the cost of the acquisition (save for some restricting charges or the like). It's mostly the balance sheet which is affected, and then costs are capitalized in future periods.

 

What do you mean by acquisition related costs? If you mean hiring an investment banker, doing due diligence, and costs integrating an acquired company, it does hit net income via SG&A.

 

Right but if the company is acquired for say $100m, it's not like net income is reduced by $100m the next year. It's only the operating pieces and any one-off acquisition-related charges (like restructuring, lawyer fees, etc) that hit net income.

 

The acq costs from the Investing section of the CF statement don't reduce Net Income by the same amount.

[SharperDingaan]

You could also stop the piddling around & just go straight to the Statement of Cash Flow 'cashflow from operations' - where the reconciliation has already been done for you. To project the operating cash flow forward - either model each line item on its own, or use some kind of adjustment factor.

 

ie: If you expect year-on-year cash flow growth of around 33.33% (oil/gas) and the last 4 quarters of operating CF were 200M, you might apply a 20x multiple to the historic 200M to get 4B. Alternatively you could project a forward CF of around 266 (33.33%) and apply a 15x multiple (because you could be wrong) to also get 4B.

 

Many would simply look to managements most recent guidance & apply a 'quick & dirty' multiple of 15-20x depending on the degree of confidence in managements numbers. If there's a sizeable hedge book removing most of the price risk, lots of drilling activity adding new barrels, & a rising commodity market - most would tend to the higher multiples.

 

SD

 

     

 

[Graham Osborn]

Wondering if most here reduce operating cash flow by any acquisition-related costs when calculating free cash flow. For serial acquirers, I think it's apt, but am on the fence when a company maybe makes a few occasional acquisitions. Curious as to hear other's thoughts on this.

 

Depends on how you want to use free cash flow. If you put a multiple on it, you are doing a shortcut for a DCF, which means you shouldn't include it unless you think it will be an ongoing expense.

 

The key is "recurring." Although it seems quaint to say, companies acquiring for the right reasons (sustainable FCF growth) make large acquisitions only periodically, and take time to digest them.  Although it would still be best to deduct the cost of acqs from FCF in this case, the sporadic nature makes it hard to forecast and omitting is an OK approximation.  Not so for repeated or serial acquirers.  We're talking repeated annual acquisitions at a decent fraction of the parent's EV.  Companies may do this for different reasons, i.e. (1) to eliminate competitors or create synergies (2) to obscure or buy their way out of poor operating results in a loose-capital environment, including from prior acquisitions (3) to take advantage of the purchase accounting rules to create artificially nice operating results.  The latter 2 reasons originate the need to deduct the total acquisition expense in CFI when acquisitions are both large and recurring.

 

Serial acquirers often tout themselves as "more efficient capital allocators." While this is conceivably true (look at historical BRK), it's not the norm.  More often management is buying crappy assets with declining or limited cash flows and then using the accounting conventions plus more acquisitions to cover up the fact.  As an extreme but instructive example, imagine a hypothetical business that purchased assets with cash flows of 1-year duration.  Those cash flows are used to purchase the equivalent amount of new assets each year.  An FCFAA analysis would show the business to have FCF=0.  Now, if we imagine each of those assets had a 5-year wasting life rather than 1, their cash flows would pile up assuming you purchased an equivalent number of assets each year.  However, more than offsetting this would be the purchase multiple to buy the assets.  This might well result in FCF<0 although the cash flows generated by the assets would pyramid for a few years before the company ran out of financing.  In both cases, FCFAA is needed to provide a picture of the "sustainable cash generating ability" of the business.