The financial media love to focus on net profit and its derivative – the price-earnings ratio (PER). Both, however, can lead you astray.
For one thing, accountants decide how to report profits, and some managements have a penchant for creativity. There’s more room to ‘fiddle’ with the income statement than with either the balance sheet or cash flow statement.
Another issue is that what a company spends buying assets, such as new machinery, doesn’t flow through the income statement in one hit, it’s smoothed out over years or decades as a non-cash ‘depreciation’ expense.
For businesses that require a lot of reinvestment to maintain and grow their operations, net profit often overstates the economic reality.
Free cash flow
What really matters to shareholders is how much cash a business produces for paying dividends, buying back stock and reducing debt, after all its bills, taxes, and capital expenditures (also known as capex) have been paid for. This is what's called ‘free cash flow’.
‘Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life’ as Warren Buffett put it.
Free cash flow (FCF) is fairly easy to calculate. Head to a company’s cash flow statement in its annual report, take ‘net cash provided by operating activities’ and deduct what the company spent buying new assets to maintain its operations, which is usually labelled ‘capital expenditure’ or ‘payments for property, plant and equipment’.
This calculation is a good starting point, but it may need some adjusting depending on the nature of the company. If a company needs to continuously purchase intangible assets such as software, for example, you probably want to throw that in with capital expenditure.
When free cash flow is positive, it means the company is generating more cash than it uses to operate and grow. However, free cash flow can be volatile due to the timing of payments, cash receipts and lumpy capex spending. It’s usually best to compare how free cash flow and net profit relate over many years.
No valuation metric is perfect, but the price-FCF ratio is arguably better than the price-earnings ratio. Better still is when it’s expressed as a yield (free cash flow divided by the company’s market capitalisation).
By comparing the free cash flow yield to the dividend yield, you can see what proportion of cash is being withheld for reinvestment. Furthermore, when the free cash flow yield consistently falls short of the earnings yield, there should be question marks over the quality of those earnings.
Free cash flow yields also put different asset classes on an even playing field for comparison. Whether you’re investing in property, bonds or stocks, what ultimately matters is what you have to pay and how much cash you’ll get out over time.
All things being equal, we’re willing to pay more per dollar of net profit if a greater chunk of it flows through as cash. In other words, stocks with a high PER might still be more attractive investments than those with a low ratio depending on their free cash flow yield.
For quality growing businesses that can reinvest at high rates of return, we’ll accept a lower free cash flow yield of, say, below 5%. For poor quality businesses, however, a much higher yield might be required, say, 8% or more.
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