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mastering cashflow
mastering cashflow
CASH FLOW
BY COMPOUNDING QUALITY
Compounding Quality
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Operating cash flow = operating income + non-cash changes - changes in working capital - taxes
CAPEX = changes in Property, Plant & Equipment (PPE) + depreciation
The operating cash flow measures the amount of cash that is generated by a company’s normal
business operations.
In other words, the operating cash flow measures all the cash a company generates by selling its
products / services.
The capital expenditures (CAPEX) shows how much money a company has used to maintain or buy
physical assets.
When a company is investing heavily in future growth, the free cash flow will decline due to the fact
that the growth CAPEX is high.
Growth investments can be very valuable if they create added value for the company.
That’s why some people prefer to only take the maintenance CAPEX into account to calculate the free cash
flow.
In that case the formula for free cash flow goes as follows:
It goes without saying that the higher the free cash flow of a company is, the better.
The company can do different things with its free cash flow:
Capital allocation (choosing what to do with its free cash flow) is the most important task of
management.
You want to invest in companies that manage to allocate capital very efficiently.
In general, reinvesting in itself for organic growth is the most preferred capital allocation strategy.
Obviously, the company needs to have enough growth opportunities in order to do this. It is also
important to underline that it only makes sense to invest in organic growth when these organic investments
create value.
This metric indicates how much cash a company is generating per dollar in sales.
Visa for example has a free cash flow margin of 60.2%. This means that for every $100 in sales, Visa
generates $60.2 in pure cash.
This in stark contrast with General Electric, which has a FCF margin of only 2.9%.
It goes without saying that it is justified to pay a higher valuation multiple for Visa compared to General
Electric.
A study of James O’Shaugnessey (What Works on Wall Street) found that companies who translated most
earnings into FCF outperformed companies that translated the least earnings into FCF by 18% (!) per
year.
That’s why focusing on the FCF margin of a company can help you a lot to make better investment
decisions.
Source: What Works on Wall Street (James O’Shaugnessey)
That’s why you should always look at the free cash flow of a company and not at its earnings.
While earnings are an accounting metric, free cash flow looks at the money that actually entered and
left the firm over a certain period.
In other words: the net income of a company contains a lot of non-cash items whereas free cash flow looks
at the cash that effectively entered and exited the business.
To go from the net income of a company to its free cash flow, you should make the following adaptions:
Free cash flow = Net income + depreciation / amortization - change in working capital - capital
expenditures
In general, free cash flow can be seen as a better metric compared to the earnings of a company
because this metric is more reliable and is harder to manipulate.
FCF conversion
Quality companies convert most earnings into free cash flow.
When there is a huge difference between the free cash flow and the earnings of a company, you should
be suspicious as an investor.
In the example below, L’Oréal is the robust, quality company whereas the cash flow conversion of BP
is more unreliable.
Source: Fundsmith
Free cash flow yield = (Free cash flow per share/ stock price)
You can compare the FCF Yield of a company to its historical average FCF Yield to get a grasp about how
expensive the company is an historic perspective.
Watch out for stock-based compensation
A lot of technology companies are giving a lot of stock-based compensation benefits to their employees to
attract and retain talent.
As a result, you should always look at the FCF per share excluding stock-based compensations to get a
more reliable and conservative view of the company.
For example, for Amazon the price to free cash flow based on the estimated free cash flow of 2023 is equal
to 36.1.
However, when you would treat stock-based compensation as an expense, the price to free cash flow would
increase to 159.2!
This is a huge difference and underlines why you should exclude stock-based compensation.
Source: Morgan Stanley
Expected return
Last but not least, you can use the following rule of thumb to calculate your expected return as an
investor:
Expected return per year = FCF per share growth + buyback yield +/- multiple expansion (multiple
contraction)
We estimate that Visa will be able to grow its free cash flow per share with 13% per year over the next 5
years. The dividend yield is equal to 0.9% and we estimate that the outstanding shares of Visa will remain
constant over the next years. Furthermore, we think the current FCF Yield of Visa (4.2%) is fair, as a result
no multiple expansion nor contraction will take place.
Under these assumptions the expected yearly return for Visa is equal to:
Would you be happy with an annual return of 13.9% per year? If so, Visa might be an interesting
investment.