Rule #1 Finance Blog

With Investor Phil Town



It isn’t 9 a.m. Monday, but I’m going to post this reader mail response today because it addresses some of the conversations you’ve been having on the blog under the EBAY post. It also addresses the right way to determine Free Cash Flow.


From Daniel, who’s done some searching and has focused in on EBAY as a possible Rule #1 company that he likes and understands:  [The bolded items are my emphasis.]


This is a company that I know about because
I use it from time to time. I also believe it has a brand recognition moat and
a competition moat (i.e., few if any real competitors). I also like its
philosophy of being a champion of small businesses and home businesses.

All of
its growth rates are spectacular over the last 9 years or so. (I calculated on
my own without your calculators so please forgive the estimates). The equity
growth rate looks to be around 60%. Sales around 84%. EPS around 55%. Then
there’s cash. A big fat 0%.
Actually, it’s lower than that. It’s in the
negative territory big time. From what I can tell, eBay has been making a lot
of big investments internationally and has engaged in some acquisitions over
the last couple of years. I am guessing that those activities are the primary
causes of its negative cash flow.

Nevertheless, using the Rule
number crunching of future EPS (I used the analysts lower estimate of around
30% rather than the Equity G.R. of 60%) and future P/E show a future EPS of
12.16 (up from .76 today) and a P/E of 60 (btw, the average P/E over the last 5
years is actually 133 but I used the lower default of 60). This all works out
to a sticker price of $182.4 and an MOS adjusted target price of $91.2. It’s
trading at around $34.

So my question is: Does the horrendous cash flow number
really negate all the other perfect numbers and take this company out of Rule
#1 territory. Or is the MOS SO large that we can overlook the cash figure and
focus on everything else.  (Also, why is it trading so low?)

Also, how would you
recommend dealing with the cash flow numbers now that companies are reporting
stock “sales” to officers and directors?  They’re bringing down
the growth rate because prior reports didn’t include those numbers.

Thanks for taking the time
to read this little treatise I’ve sent you.


Here’s my response:

A year ago EBAY had an
analysts telephone call and Meg Whitman announced that Ebay wasn’t
going to grow at 40% or 305
.  It was going to have around 20% long term
sustainable growth.  And the stock immediately crashed 30% on
the news.  (I use this in my talk as an example of how great it is
to be using tools that tell you the big guys are getting out.
The red arrows were on the screen a week before her announcement.)

A year later, Ebay’s growth
rate is well above her projection, so what do we make of what she
said?  Was she low balling and hedging the future, or was she making a
serious and accurate call about the growth rate? 

I don’t
know.  It appears that a lot of analysts that follow Ebay think she’s low balling
and they’ve kept their estimates averaging in the 30%
range.  If we use that rate of growth and a 50 PE (I never go higher than 50
no matter what the growth rate is)… I get a Sticker of $120 or so
with an MOS of $60.

But if I take her at her
word and use a 20% growth rate, I get a 40 PE, a Sticker of $48 and an
MOS of $24.

The stock is selling for $36.

This valuation process seems
to indicate that I wasn’t the only guy in the world who heard the
phone call last year, doesn’t it?

Now, what about that nasty
free cash flow?    Free Cash Flow is not a reported number by most
businesses.  It ain’t GAP accounting.  It’s business owner
accounting.  Here’s how you get it:

Go here, to the Cash Flow Financial Statement.

Note, 7/31/06: This post has been updated to reflect recent changes to the MSN layout of financial statements.

Take Cash from Operating Activities (sometimes called Net Cash Provided by
) and subtract the Capital Expenditures. (The line directly underneath.)

(On other research sites, this is
usually a line item under Cash Used in Investing Activities.) 

Note:  you should
NOT subtract Cash Used to Buy a Business!  That’s just cash invested in
other businesses, not cash used to keep this one running. 

Cash Flow is the cash a business has left over AFTER it subtracts what
capital items it needs — things like manufacturing plants and
replacing machinery that broke.

Ebay didn’t spend its cash on stuff like
that.  It spent it on buying up other businesses.  Not the
same thing.

What that means is that MSN
Money is not calculating Free Cash Flow correctly because they mix
in business purchases. (Update, 7/31/06:  If you simply subtract Capital Expenditures from the line right above it, as described above, you’ll be OK.) 

My bad.  I missed this.  Should have
caught it but I personally use Investools for the Cash Flow numbers simply
because they track them back 10 years and MSN only goes back 5. 

that means you’re going to have to calculate Free Cash Flow on your own
(or get Investools).  Not a huge deal.  You can do it by going to the
SEC documents that EBAY files and taking the numbers from there.  (Useful info: Annual Reports, Financial History and SEC Filings.) That is what Investools does for us.

Here are the Ebay Free Cash Flow

Free Cash
Flow      0    8    -8    -31    44    194    341    508    983    1,656

Suddenly EBAY’s Free Cash
Flow growth looks awesome.  Up 40% or more per year.  Schweeeeeet.

Makes me an EBAY buyer
(because even with the lowered expectations I’m still below the Sticker by
more than 20%, so I get to buy back in on the arrows.)

Hope that helps.

Now go play!

Phil Town