In my work as an Equity Analyst I am currently having great difficulty finding stocks to invest in that provide me with an adequate margin of safety. This usually is a sign that the markets are overvalued and could be heading for a correction. Besides being an Equity Analyst, I am also a Portfolio Manager for Conservative Equity Investment Advisors, a registered investment advisory firm, where most of my clients are retirees. That being the case, I try to be conservative and demand an adequate margin of safety when picking stocks for them. The system I employ to determine this margin of safety are based on the following three methods used to calculate free cash flow:
Standard Free Cash Flow Per Share
(Cash Flow from Operations – Capital Spending)/Diluted Shares Outstanding
Levered Free Cash Flow Per Share
(Formula: (EBIT + Interest Expense) * (1 – Tax Rate) + Depreciation & Amortization., Total + Other Amortization + Capital Expenditure + Sale (Purchase) of Intangible assets – Change in Net Working Capital + Pref. Dividends Paid + Total Debt Repaid + Total Debt Issued + Repurchase of Preferred + Issuance of Preferred Stock)/ Diluted Shares Outstanding
Where: Tax Rate = 0.375
This figure is a normalized item that excludes non-recurring items and also takes into consideration cash inflows from financing activities such as debt or preferred stock issuances.”
Owner Earnings Per Share (Warren Buffett’s formula for measuring Free Cash Flow)
(Net Income +Depreciation, Depletion, Amortization + Certain Non Cash Items – Capital Expenditures + Changes in Working Capital)/Diluted Shares Outstanding
Actual Calculation of IBM’s Owner Earnings for 2012 as an example:Â
Net Income = $16,604
D&A = $4,676
Other Non cash Items =$688
Cap Ex = -$4,717
Changes in Working Capital = $-2449
Therefore (16,604) +(4,676) +(688) -4,717 = $17,251
Then finally you take that 17,251 and add (not subtract) the changes in working capital =$17,251 + $2,449 = $19,700
