Net earnings, free cash flow and valuation rules of thumb
Everybody knows that the best way to value a stock or a company is to use a discounted cash flow analysis. Warren Buffett tells us: “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.” (Buffett W. E., 1998)p. 187.
Price earnings ratios are simply a rule of thumb. They can lead you astray. But what is worse, they are becoming less and less valid with every passing year.
I can illustrate this by referring to a figure I used in my last post, The hunt for wonderful businesses. It shows the 5 year average price earnings ratio for six well-known companies and compares their 5 year average price to free cash flow ratios. You might expect that most companies will have higher net earnings than free cash flow. Let’s look:
Every single one of these companies has a lower average price to free cash flow ratio than price earnings ratio. That is, their free cash flow is higher than their earnings. Why is that?
Let’s first understand the relationship between earnings and free cash flow. In simple terms the net income of a company is the cash from operations less depreciation, depletion, amortization (DDA), and certain other non-cash charges. On the other hand, free cash flow is the cash from operations less capital expenditures and other investing activity (capex).
Simply put, if a company is spending less on capex than its DDA, it will have higher free cash flow than reported earnings. At first blush this should be a recipe for disaster. DDA is supposed to roughly indicate the need for capital spending. Spend less than needed capital spending and the company will wither.
So, are these six companies playing out the string by using and running down their assets to generate unsustainable free cash flow today? The answer is no. To be objective, I have never held shares in any of these companies. To understand the issue we need to understand more about company investment in intangibles.
Here’s the key: Companies that create intangible assets internally are, with certain limited exceptions, required to expense the related cash outlays.
As a result, the cost of creating major long-lived corporate intangible assets ends up reducing net or reported earnings while, at the same time, creating long-lived intangible assets that do not appear on the balance sheet.
While almost all business sectors are investing in intangibles and manufacturing seems to be growing intangible investments faster than the service sector, the impact is different in different sectors. For manufacturing companies, the growth of intangibles investment may serve to somewhat lower reported earnings. For the tech sector and some other sectors, the impact may be more dramatic.
Is this a big issue? You bet it is and it’s getting bigger. The following chart shows the relative share of company investment in tangible vs intangible investment. It comes from a wonderful book Capitalism without Capital, the Rise of the Intangible Economy (Haskel & Westlake, 2018).
As Warren Buffett put it in his 2015 annual letter to Berkshire Hathaway shareholders in February 2016: “…serious investors should understand the disparate nature of intangible assets. Some truly deplete in value over time, while others in no way lose value.” What Buffett is saying is that some, but only some, intangible assets do not depreciate and can continue to generate returns for years without further investment.
So let’s return to the point we started with. If some intangible assets do not depreciate and can continue to generate returns for years without further investment, this explains how some companies are able to spend less on investment than the non-cash charges for DDA and still be wonderful growing profitable businesses. One final fact regarding intangibles; if you take the market capitalization of the S&P 500 as the market’s way of pricing corporate assets both tangible and intangible, the intangible portion is over 80%. If you look at it this way, intangible assets make up over 80% of the assets of S&P 500 companies.
It would seem from this discussion that net earnings are becoming less and less relevant to assess company performance and less and less valid as a shorthand indicator of intrinsic value. It has been said that reported earnings are an opinion whereas cash is a fact. If investors are going to use rules of thumb perhaps price to free cash flow is a better gauge of value. Maybe we should be looking at price to free cash flow ratios instead of price earnings ratios.
This issue impacts investing in many ways. See here for impact on CAPE.
See here for impact on Return on Capital.
And see here for impact on Book Value.
Want to read more about the issues raised in this post, take a look at Part 7: Building and managing a portfolio and specifically Chapter 38. The Problem of Determining Intrinsic Value and Chapter 39. Use of ratios to value shares and especially Section 39.13 Earnings and investment in intangibles and Section 39.14 Price to free cash flow ratio .
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