To perform a company valuation, investors make use of several metrics that convey its current position and future performance. One of the key metrics in this is the Free Cash Flow (FCF). Its calculation involves items that are part of the CashFlow Statement.

The cash flow statement is one where inaccuracies are somewhat common in published annual reports in the ‘ESEF’ European electronic format. A significant part of these inaccuracies are sign errors on items that contribute to the calculation of the FCF. The difference between the correct value and the disclose value is ‘just’ the sign,a single character on a single line. But that difference, in a domino effect,is likely to severely affect the calculation of the FCF and and ultimately impacting the company’s valuation.

Before exploring the reasons behind this issue, a quick word on the Free Cash Flow and their importance in the evaluation made by financial analysts and investors.

The Free Cash Flow: a key measure of a company’s financial health

Understanding the Free Cash Flow calculation is crucial for both analysts and issuers, given its major role in company valuations. It represents the cash remaining after covering day-to-day operating expenses and capital expenditures (excluding non-cash expenses such as depreciation or amortization).

The significance of FCF lies in its calculation ,reconciling net income while adjusting for non-cash expenses, changes in working capital, and capital expenditures. It offers a more concrete measure of profitability compared to traditional metrics such as earnings that can be affected by ‘disclosure management’ practices. It is very commonly used by analysts as measure of  how efficiently acompany converts its sales into cash.

A consistently positive free cash flow is a sign that a company is generating more cash that it spends, a sign of a healthy and sustainable business. It also represents a capacity to repay debt, pay dividends or invest in new projects to seize growth opportunities. Of course, investors will be very cautious about sudden changein Free Cash Flow.

A sudden drop in FCF may become a focal point for investors, signifying potential financial challenges or inefficiencies, such as not generating enough cash from its operational activities to cover its capital expenditures.

Conversely, an uptick in FCF could signal improved financial health and efficiency in managing the company’s cash resources. This improvement, driven by generating more cash from operations than investing in capital expenditures, provides assurance to potential investors regarding the company's capacity to repay debt, distribute dividends, or invest in growth opportunities.

The most important property of the FCF an analysts uses is that it must be accurate. Data that is not seen as trustworthy will drive away analysts whether the FCF is favorable or not. This might seem obvious, and yet…

How ‘minor’ sign errors cascade into incorrect FCF calculations

A notable issue within ESEF reports is the prevalence of sign errors, as highlighted by statistics from 2022 and 2023 reports. Sign errors involve inaccuracies in reporting financial values, wherein positive amounts are incorrectly presented as negative, and vice versa. However subtle, this issue can set off a chain reaction of errors and thus invalidate crucial calculation such as FCF… with consequences that extend far beyond mere compliance issues.

When sign errors infiltrate components of FCF, such as the misclassification of cash inflows and outflows, the ensuing calculation leads to an inaccurate portrayal of the company’s financial standing – either overvalued or undervalued. This distorted picture of the company's health has significant implications for analysts and investors, potentially misguiding their investment decisions and portfolio performance. That’s why investors are very cautious about the quality of issuers’ financial data: since a single inaccurate data may invalidate their entireanalysis.

Surprisingly,these errors are more common than you think. Despite a slight decrease from 2022, 30.9% of 2023 ESEF reports contained sign errors. Feedback from our database repeatedly showed errors on metrics such as ‘Taxes paid/refund’,‘Interest paid/received’, and ‘Net profit/loss attributable to non-controlling interests’. For instance, a quick glance into the 120 ESEF reports collected in the first week of March, 2023, revealed more than 90 sign errors across the 120 reports! We will soon see if issuers have improved this year.

How can these errors be so prevalent? Are companies being careless with such a cornerstone of investor confidence? Certainly not. The persistence of such errors stems fromvarious reasons, as explored in previous blogposts. However,resolving the issue requires acknowledging the full scope of the problem and understanding why FCF is arguably one of the most important metrics issuers should vigilantly monitor when drafting their ESEF reports.

A $41 billion misvaluation: a real-life case study in the luxury sector

To demonstrate the substantial impact of a seemingly minor sign error on a company’s valuation, here is a real-world example from the luxury sector, featuring anonymized data.

Within this company’s report, a sign error appears in the ‘increase (decrease) in working capital’ indicator. Let’s see how it affected the overall valuationof this company.

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When entering this metric, the issuer recorded '-902' instead of '902'. Consequently, all operations stemming from this indicator were distorted, leading to a misrepresentation in the calculation of FCF: the result obtained was 4188, whereas it should have been 2384.

The explanation for this error lies in the fact the'increase(decrease) in working capital' indicator was mistakenly considered as a cash inflow instead of a cash outflow. The cascading impact on subsequent operations is extremely severe: with a correct calculation and the current market capitalization we can conclude that this company is trading at 23 times its FCF. This seemingly minor mistake translates into a staggering valuation change of $41 billion!

This example alone serves as a cautionary tale about how simple errors in ESEF annual reports extend beyond mere compliance issues. The solution won’t come from thinking that these errors don’t occur very often. As demonstrated, they do occur frequently, with an undeniable impact on company valuations.

To solve these issues, delving into the intricacies of the ESEF taxonomy is a critical first step. But the real key lies in harnessing solutions designed to detect any questionable metrics. Corporatings stands out as a dedicated tool that enhances data accuracy while facilitating end-user access to raw data and harnessing the potential of ESEF regulation for benchmarking purposes. Issuers can always check out how their data are reported by using our tools.

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