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Bill Ackman: Free Cashflow Is All

You Should Care About
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one term often stands out as a beacon for seasoned investors: free cash
flow. Championed by investment mavens like Bill Ackman, this metric

serves as a litmus test for business excellence and financial resilience.

But why does free cash flow garner so much attention, and why is it
hailed as the touchstone in value investing? Keep reading to learn the
significance of free cash flow, drawing from the wisdom of investing

legends and crystallizing lessons that could help your long-term

investment strategy.
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 investment strategy.

Bill Ackman On The Importance Of Free

Cash Flow
Here is the transcript of an interview where Bill Ackman talks about the
importance of free cash flow in valuing an investment.
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The interviewer said, “Go through that strategy and go through how it

works. And when you come, you know, maybe you’ll override that
portfolio manager. But what’s the checklist you kind of go through?”
:
 Bill Ackman explained, “So, we look for very high-quality businesses what
we describe as simple, predictable, free cash flow generative, dominant
businesses. A business that Warren Buffett would describe as having a
moat around it. Right? If you believe that the value of anything financial is
the present value of the cash you can take out of it over its life, well, you
need to know how much cash it’s going to generate over its life. So,
business quality, to us, is the single most important criterion for
determining what’s interesting. Because if we can’t predict the cash
flows, we don’t know its worth. If we don’t know its worth, we can’t invest.

And we figure out what it’s worth, figure out how good the business is, report this ad

how predictable these cash flows will be, whether it’s from a railroad or a
spirits company or a real estate company, a shopping mall business. And
then we say, ‘Okay, well, where’s it trading?’ And if there’s a wide gap
between price and value, if you can buy for 50 cents what’s worth a dollar
twenty, well then, we’re going to take a hard look and try to understand
why it trades at a deep discount. And once we understand the reasons,
we decide: Are these things that we can solve? In light of the situation
and circumstances, can we be influential in changing these levers that
can cause this valuation discrepancy to narrow? And is this a business
that, while we’re causing the valuation discrepancy to narrow, we can
also perhaps contribute to the valuation growing? If those things are true,
we’ve found something that looks quite interesting for us.”

The interviewer interjected, “And usually, this investment philosophy —

does it take a week, a month, three months to do the research, a year? I

mean, you have ten names. How long?”
:
 mean, you have ten names. How long?”

Bill Ackman continues, “It depends. One of the best investments we’ve
ever made took us four hours to do the work. It was during the financial
crisis. It was that Wachovia Corporation. I was on my BlackBerry, eating
breakfast at The Brooklyn Diner in front of my building, and a story went SPONSORED CONTENT
across — it was a Wall Street Journal headline, no, excuse me, a
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Reuters headline — saying that Citigroup was to acquire the Wachovia Work Management Wit
banking subsidiaries for two dollars in Citigroup stock. The stock was Smartsheet 
halted. This was an interesting transaction because they were buying the By Project-Management.com

subsidiaries with Citigroup stock. I thought, ‘That’s interesting. What

happens to the holding company?’ So, I went back to the office and
cracked open the 10K. Another member of the team, Mick McGuire, he
and I worked on it. What was interesting is, in the thousand-page 10K of
Wachovia Corporation, I think 900 pages were about the banking

subsidiary. There were fewer than 100 pages about the holding company.
By buying the banking subsidiary, Citigroup was leaving a holding
company which had cash, assets like Wachovia Securities, A.G. Edwards
— they had paid six to seven billion for it just four to six months before —
and Evergreen asset management. And they were taking a 27 billion
dollar loss on the sale of the subsidiary. It also had a liability called non-
cumulative perpetual preferred stock, which is the best kind of liability to
have. It’s a form of equity where you never have to pay a dividend, and
when you don’t pay, the dividends don’t accumulate. Worst case, they get
a couple directors on the board, and you just say hi to them at each
meeting. So, this was very interesting. I said, ‘This could be our Berkshire
Hathaway.’ By the end of the day, we figured that the holding company
was worth at least 11 to 14 in cash. A tax refund that you could carry
back the 27 billion dollar loss, recover cash taxes that had been paid, this
cash vehicle. Wachovia Securities, which was a good wealth
management business, A.G. Edwards, and other assets, these are
businesses we knew well. And the stock opened after it was halted, at a
dollar eighty-four. So, we said, ‘It’s worth 11 to 14, it’s at a dollar eighty-

four,’ and we bought 42% of the volume for the next four days. And then
Wells Fargo came in and put in a topping bid of seven dollars in Wells
:
 Wells Fargo came in and put in a topping bid of seven dollars in Wells
Fargo stock, which wasn’t actually a topping bid, but the Wells Fargo deal
did not require government assistance.”[1]

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Why Do We Care About Free Cash Flow?

Bill Ackman and Warren Buffett, renowned value investors, have often
emphasized the importance of free cash flow (FCF) when evaluating
businesses for potential investment. Here’s why free cash flow is deemed
so crucial in making value investing decisions, drawing upon the
teachings of these two investment giants:
:
 1. Fundamental Definition of Value: At its core, the value of any
financial asset, be it a bond or a stock, is the present value of the
cash flows you can expect to receive from it over its life. For stocks,
the relevant cash flows are the dividends or, more broadly, the free
cash flows the company can generate and distribute to its
shareholders.
2. Indication of Business Quality: Free cash flow directly reflects a

company’s ability to generate more cash than it needs to reinvest in

its business. A company that consistently produces strong free cash
flows is likely a high-quality business with a competitive advantage
or “moat,” as Buffett would describe it. This moat allows the
company to earn returns on capital that exceed its cost of capital.
3. Flexibility and Optionality: Companies with robust free cash flows
have more flexibility. They can reinvest in their business, make
acquisitions, pay down debt, buy back stock, or pay dividends. This
financial flexibility is a significant advantage in both good times and
bad.
4. Protection against Over-optimism: Earnings often highlighted in
financial reports can be manipulated with accounting tricks. Free
cash flow, a more direct measure of the cash that flows in and out

of business, is harder to manipulate and often provides a clearer

picture of a company’s financial health.
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 picture of a company’s financial health.
5. Indicator of Management Quality: How management deploys free
cash flow can provide insights into its capital allocation skills. Buffett
has always admired managers who allocate capital in a manner
that maximizes shareholder value.
6. Discount to Intrinsic Value: Value investors like Ackman and

Buffett look for discrepancies between price and value. An investor

can ascertain a company’s intrinsic value by estimating the present
value of future free cash flows. It might be a good investment
opportunity if the stock trades below this intrinsic value.
7. Sustainability of Business Model: A company that consistently
generates positive free cash flow will likely have a sustainable
business model. In contrast, firms that fail to produce free cash flow
may struggle to maintain their operations in the long run without
external financing.
8. The Basis for Dividends and Buybacks: Only with positive free
cash flow can a company sustainably return money to shareholders
through dividends or share buybacks. A company that pays
dividends without the support of free cash flow may be
overextending itself, which could be a red flag.
9. Cushion Against Economic Downturns: In challenging economic
times, companies with strong free cash flow have a buffer to
weather the storm, whereas those without might face financial
distress.

While other metrics and qualitative factors are undoubtedly important,

free cash flow is a particularly crucial measure in value investing due to
its direct link to business quality, financial health, and intrinsic value.
Ackman and Buffett have used it as a foundational component in their
investment philosophies, reiterating its importance in value investing.

Key Takeaways

Core Essence of Asset Value: The true worth of any financial

instrument pivots around the present value of prospective cash
:
 instrument pivots around the present value of prospective cash
inflows from it.
Benchmark of Business Excellence: Steady free cash flows often
signal a dominant business fortified with a competitive edge.
Financial Versatility: Firms with ample free cash flow enjoy
diverse options, from debt reduction to strategic reinvestments.
Guard Against Financial Embellishments: Unlike easily-
manipulated earnings, free cash flow offers a more transparent
view of fiscal well-being.
The Gauge of Leadership Prowess: Observing how leaders utilize
free cash flow can reveal their acumen in capital management.
Indicator of Undervaluation: Estimating future free cash flows can
spotlight stocks trading beneath their value.
Sustainability Marker: Positive free cash flows hint at a resilient
and enduring business model.
Underpinning for Shareholder Returns: Dividends and stock
buybacks rely on the foundational support of free cash flow.
Economic Downturn Buffer: Businesses flush with free cash flow
are better equipped to navigate financial turbulence.

Conclusion
Free cash flow emerges as a paramount metric for valuing a company,
acting as both a beacon and a safeguard in the complex investing world.
Drawing inspiration from Bill Ackman’s insights, it’s evident that this
measure doesn’t merely represent numbers but encapsulates a
business’s vitality, resilience, and essence. A firm’s ability to consistently
generate and astutely allocate free cash flow is a testament to its
financial strength. It’s an indispensable tool for discerning investors
aiming to uncover actual value in the marketplace.

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