P 313, bruce berkowitz to value equities, we at fairholme begin by calculating free cash flow.

We start with net income as defined under GAAP. Then we add back noncash charges such as depreciation and amortization, which are formulaic calculations based on historical costs (depreciation for tangible assets, amortization for intangibles) and may not reflect a reduction in those assets true worth. Even so, most assets deteriorate in value over time, and we have to account for that. so we subtract an estimate of the companys cost of maintaining tangible assets such as the office, plant, inventory, and equipment; and intangible assets like customer traffic and brand identity. Investment at this level, properly deployed, should keep the profits of the business in a steady state. That is only the beginning. For instance, companies often misstate the costs of employees pension and postretirement medical benefits. They also overestimate their benefits plans future investment returns or underestimate future medical costs, so in a free cash flow analysis, you need to adjust the numbers to reflect those biases. Companies often lowball what they pay management. For instance, until the last several years, most companies did not count the costs of stock option grants as employee compensation, nor did the costs show up in any other line item. Some went so far as to try to mask this options expense by repurchasing large quantities of shares in the open market to offset the stock options exercised by employees. The problem: companies were often paying much more on the open market than they received from employees exercising options granted years before. This difference was rarely reported as an official costs of doing business. Another source of accounting-derived profits comes from tong-term supply contracts. For instance, when now-defunct Enron entered into a long-term trading or supply arrangement, the company very optimistically estimated the net present value of future profits from the deal and put that into the current years earnings even though no cash was received. Enron is gone, but not the practice. Insurance companies and banks still have considerable leeway in how they estimate the future losses arising from insured events or loan defaults. And for any company, gains and losses on derivate contracts are difficult to nail down with precision since the markets for such instruments are thin. Some companies understate free cash flow because they expense the cost of what are really investments in their growth. For instance, adding new auto insurance customers may cost as much as 20% to 30% more than the cash received from new policyholders in their first year. Some of this excuess ost goes to replace customers who did not renew their policies. But if the number of policyholders is growing, a portion of the expense represents investment in growth. Berkshire Hathaways GEICO subsidiary does just this, and as a result, accounting earnings understate free cash flow assuming a steady-state business. When Microsoft sells a Windows program, the company recognizes that future servicing costs are part of that sale. Microsoft accounts for these costs by spreading the revenues and expenses over a number of years. The result is to defer profits to future periods and provide the company with a cushion against future adverse developments.

All of these noncash accounting conventions illustrate the difficulty of identifying a companys current free cash flow. Still, we are far from done. My associates and I next want to know (a) how representative is current cash flow of the average past flow, and (b) is it increasing or decreasing- that is, does the company face headwinds or ride on tailwinds?