Depreciation is an expense that matches the cost of a fixed asset against the revenues it helps to produce.  The cost of an asset is spread over its useful life.    The most common method of depreciating an asset is known as straight-line depreciation, where an equal amount is charged against revenue over the asset's useful life and is calculated as follows: straight line depreciation = (cost - residual value) / estimated useful life Depreciation is often seen as a proxy for maintenance or stay in business capex.   The problem with depreciation is that the management o ..read more

 Summary Expenses and depreciation reduce profits.  Capex reduces FCF. When expenses are not expensed against revenues but considered as capex, the company will report higher profit.  Also, the depreciation charge reported by the company will be probably too low. In a nutshell: the cash spent should be expensed against revenues and so it should reduce profits.   unless it does, this, the depreciation charge reported by the company is probably too low and profits too high.    Four simple rules when comparing FCFps with EPS when looking for possible investme ..read more

We can use free cash flow as a tool for checking the quality of a company's profits. The stock market has been littered with companies that seemed to be very profitable but turned out to be anything but. Investors can save themselves a lot of heartache and some painful losses by taking a few minutes to study how effectively a company converts profits into free cash flow. One of the simplest and best ways to test the quality of a company's profits and whether you think they are believable or not is to compare a company's underlying or normalised earnings with its free cash flow.    Th ..read more

Dividends are an important part of total returns from owning a share.   Dividends are a cash payment and therefore the company needs to have enough cash flow to make these payments. Compare the FCF with its dividends By comparing the free cash flow with its dividends, you can see whether a company has sufficient cash to pay dividends.   Net cash from operation - CAPEX =  Free Cash Flow You want to see the free cash flow being the bigger number more often than not. When dividend is the larger number compared to the free cash flow, this may occur when a company is putti ..read more

Free cash flow comes with a few caveats one need to be aware of. Besides calculating a company's free cash flow, one need to study its cash flow statement closely to really find out what is going on. Example:  Company Property X - no free cash flow but paying dividends Operating profits  830m Other (operating) (648m) Operating cash flow 182m Tax paid - Net cash from operations 182m Capex (441m) Free cash flow (259m) Equity dividends paid (139m) This is a property company.  Making money from selling properties (assets) is a normal part of its day-to-day activities.  It mak ..read more

BIGGEST RISK:  PAYING TOO MUCH The biggest risk you face to be a successful investor in shares is paying too much.    It is important to remember that no matter how good a company is, its shares are not a buy at any price. Paying the right price is just as important as finding a high-quality and safe company.   Overpaying for a share makes your investment less safe and exposes you to the risk of losing money. USUALLY HAVE TO PAY UP FOR QUALITY Be careful not to be too mean with the price you are prepared to pay for a share.   Obviously, you want to buy a sha ..read more

Paying too much for a share can result in disappointing returns. No company, no matter how good, is a buy at any price. Share valuation is not an exact science.  Your valuation will never be exactly right, but by setting yourself some limits, you can reduce the risks that come from overpaying for shares. However, there is some evidence to suggest that paying what might seem to be a moderately expensive price (slightly more than the suggested maximum) for a quality business can still pay off in the long run.   The caveat here is that you have to be prepared to own shares for a ..read more

If you are going to buy and own expensive shares, you must be very confident that high rates of growth can continue for a long time into the future.   Since no one can predict the future accurately, you need to protect yourself by not paying too high a price for shares. Knowing how to value shares and understanding the crucial relationship between cash profits and interest rates are important.  Know how much of a company's current share price is based on its current profits and how much is related to future profits growth.   Though profits growth is important in valuin ..read more

Setting a maximum price and buying price for Company X shares Current cash profit per share 11.6 sen Divide by interest rate [inflation +3%]  4.4% Maximum price (cash profit / interest rate)   $2.636 Current price  $3.20 Ideal price at 15% discount $2.24 Cash yield at ideal price (cash profit/ideal price)  5.18% ANALYSIS: This approach is saying that Company X shares are currently too expensive to buy. The most (maximum price) you should pay is $2.63 per share, compared with a current share price of $3.20. If you want even more of a buffer (margin of safety) compared ..read more

 EPV gives an estimated value of a share if its current cash profits stay the same forever. Calculation: 1 Normalised or underlying trading profits or EBIT 2. Add back D&A 3. Minus Capex 4. Derive Cash Profit or Owner earning 5.  Tax this cash profit by the company's tax rate.   6.  Divide by a required interest rate to get an estimate of total company or enterprise value. 7. Minus debt, pension fund deficit, preferred equity and minority interest to get a value of equity.  Add any surplus cash. 8.  Divide by number of shares in issue to get an estimate ..read more