The hunt for wonderful businesses

Economic Performance

Use of free cash flow yield to understand impact of intangibles

For our concentrated portfolio of common stocks we want only super companies. We may be invested in some fifteen or twenty companies. We want only companies that make a lot of money on a sustainable basis. A good measure of their economic performance is an excess return on capital (ROC). But as we saw in my last post – Be wary of using Return on Capital (ROC) – there are shortcomings to that measure. There are times when management has the use of capital not shown on the balance sheet and ROC numbers can be unduly flattering to management. I suggested that the use of measures of free cash flow might help us.

To set the scene for a free cash flow discussion, let’s remind ourselves of the meaning and importance of economic goodwill. As quoted in my last post, Warren Buffett tells us: “Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring economic goodwill and that utilize a minimum of Tangible Assets”. (Buffett, 1998)p.171.

Corporate balance sheets are pretty good at showing tangible assets. They fail miserably to show economic goodwill. Economic goodwill is an intangible asset. It is created over the years by companies investing in intangibles that generate lasting value. If a company is taken over, the acquiring company will book the target company’s economic goodwill as an asset and show it on its balance sheet as accounting goodwill.

The stock market roughly prices economic goodwill. It is the portion of the market price of a stock that exceeds the book value of a company’s tangible assets. If a company shows minimal goodwill and intangibles on its balance sheet, economic goodwill is approximately the excess of a stock’s price over its book value. So, for example, if such a company trades at 2X book, the excess over 1X book value is a rough indicator of economic goodwill. If a company with a stock price of $100 has $25 of tangible assets on its balance sheet and $25 of intangibles and goodwill on its balance sheet, its economic goodwill is roughly $75. Such a company might be of interest to Warren Buffett.

Let’s assume our $100 stock has no debt. If it earns $10 per share in one year, its ROC is 20%. That is because the company has capital of $50 according to its balance sheet, made up entirely of equity. Most analysts would say a 20% ROC is pretty good. But, in truth, management has the use of $25 of tangible assets and $75 of economic goodwill. In boxcar terms, the company really has a ROC of 10% if you include both tangible assets and economic goodwill in its capital. The standard analysis using ROC is to compare it with a company’s cost of capital, specifically its weighted average cost of both equity and debt capital (WACC) to see if the company is earning excess returns over its cost of capital. If a company’s WACC is 10%, an ROC of 20% looks pretty good. But, if its ROC is only 10% (fully including economic goodwill), the company is spinning its wheels.

The trick here is that we have used market price to give us a rough indicator of effective equity capital. The next step in our analysis is to come up with a number for companies that tells us if the company is making an excess return even if we charge management with the full cost of economic goodwill.

Our friend here is Owner Earnings, another Buffettism. Owner Earnings per Buffett: ”represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume….” Roughly, this translates to free cash flow. A company that, year after year, generates handsome free cash flow is most likely to be a company that is generating a return on capital, including economic goodwill, substantially in excess of its cost of capital.

The way we arrive at that is to look at the price of the stock, the market capitalization of equity including economic goodwill, and see what sort of free cash flow yield the company is producing. The higher the free cash flow yield on price the higher the company’s excess earnings.

I am happy to let others do my arithmetic for me. I have selected six companies that have pretty healthy ROC numbers. I don’t own any shares in them so as not to bias things. The five year average price earnings ratios and the five year average price to free cash flow ratios come straight from Morningstar. I have done the work of calculating the free cash flow yields. The free cash flow yield is simply 100 divided by the average price to free cash flow.

The stocks are listed in no particular order. What is immediately obvious is that there is a big range of historic average free cash flow yields. Over the last five years Apple, VMware and Rockwell have generated significant free cash flow. We can make out a case they are capable of generating substantial Owner Earnings. Apollo Global seems to be a money spinner and would also most certainly be a candidate for designation as a generator of Owner Earnings. Amazon, not so much.

The Free Cash Flow yield numbers above are based solely on equity, similar to a return on equity (ROE) calculation. If a company has debt, one has to add that to come up with Enterprise Value. It is a simple matter to come up with a figure for Free Cash Flow yield on Enterprise Value.

All of the above are simply numbers. They are only one small step in deciding if these are companies we want to invest in. Only the most wonderful companies will make the cut. Our standards are pretty high.  Our real task is to carry out a business analysis. The numbers are simple an assist. They do not determine the outcome. As Warren Buffett has written: “When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett W. E., 1998)p.63.

None of the above is investment advice.

Want to read more about the issues raised in this post, take a look at Part 6: The Hallmarks of Superb Businesses, Chapter 31. General approach to choosing common stocks, Chapter 35. Capital Structure, Strength and Economic Performance, and specifically Sections 35.16 Measuring Economic Performance and 35.24 Free cash flow yield and the Sections that follow.

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