Making sense of free cash flow numbers

Superb businesses

Large amounts of incremental capital

Investors like to invest in companies that make lots of money. Our hunt is for superb companies and we want to buy them at bargain prices. This post takes a look at the question whether making lots of money is the same as making lots of free cash flow and whether that really helps us identify the seven footers.

My main conclusion is that financial ratios are helpful but must be treated with caution. It is all too easy to use rules of thumb and not really know what you are doing.

I never tire of this quote from Warren Buffett on the subject of what makes for a great company: He tells us: “Leaving the question of price aside, the best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return.” (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America. 1998) p.86. (Emphasis added)

In a nutshell, Buffett is looking for companies that: (a) produce large amounts of incremental capital; (b) can employ this excess cash at very high rates of return; and, (c) can do this over an extended period. All of these qualities tend to be present in companies that produce a great Return on Invested Capital (ROIC). But not necessarily. See my post: Be wary of using Return on Capital (ROC)

The key expression here for present purposes is “large amounts of incremental capital”. It’s what Buffett calls owner earnings.

Many investors focus on the statistic of five years of historical growth in revenue and earnings rather than examining the root ROIC and Free Cash Flow that lead to that growth. Historic growth tells us very little about the future.

One doesn’t have to predict future earnings so much as identify companies that have the Free Cash Flow to invest for future growth. This is the important first step in determining whether this is a business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.

Let’s look at some concrete examples. My purpose is not to suggest or recommend companies for readers to invest in. It is simply to suggest the right questions to ask and how to go about it.

A screening exercise

Our Toronto Globe & Mail newspaper business section recently contained an article written by an analyst at Inovestor, a company based in Montreal that offers stock research tools. The article explained that they had carried out a screening exercise to identify U.S. companies with a robust free-cash-flow-to-capital. The screen covered companies with a market capitalization between $5 and $10 billion.

Two input process

There are two inputs to the screen. The first is Free Cash Flow (FCF). The second is Capital (CAP). It would be tempting to select and invest in stocks that do well in the screen. That would be a mistake. Stock screening is not the end of stock analysis. It is the beginning. The article warns investors to do further research before investing in any of the companies.

Rules of thumb can be misleading

The metric FCF/CAP is a classic example of how simple rules of thumb can be misleading. The same can be said in spades for Price Earnings ratios, Price to Book ratios, Debt/Equity ratios and many others.

I have highlighted the column listing 5 year FCF/CAP. As a case in point, let’s dig into Dropbox which shows a 22.3% 5 year FCF/CAP. It is top of the class. The lowest 5 year number is 6.3% for API Group.

From the screen to the financial statements

I’ve gone to Dropbox’s financial statements and Morningstar reports on the company and pulled out some numbers. Here are some selected figures in a table:

First input: Free Cash Flow

What jumps out immediately is the difference between Net Income and Free Cash Flow. If you look only at the FCF numbers they look very solid. To understand how a company can lose $256 million in reported earnings in 2020 and yet show FCF that year of $491 million you need to read and understand the company’s cash flow statement. One big item in that statement is Stock Based Compensation (SBC). The company pays in the order of $300 million per annum in SBC. This is a non cash item. But it dilutes shareholders equity. Any investor thinking of investing in shares of Dropbox would need to study the Cash Flow Statement carefully.

I don’t propose to do a complete analysis. The message here is simple. Investors need to be able to read and understand company Cash Flow Statements. As Warren Buffett put it in his 1986 Chairman’s letter: “…accounting is but an aid to business thinking, never a substitute for it.”

I have written earlier posts about reading and understanding Cash Flow Statements.

Back to basics about free cash flow

Heart of stock valuation: subtleties of free cash flow

Negative free cash flow can be desirable

And for readers wishing to dig further, take a look at Michael Mauboussin’s report titled Categorizing for Clarity – Cash Flow Statement Adjustments to Improve Insight.

Second input – Capital

What the screen was looking for was robust free-cash-flow-to-capital. One way to come up with a figure for company capital is to use the balance sheet by adding the book value of the company’s equity to the book value of its debt and then subtracting excess cash, marketable securities and assets of discontinued operations.

We can look at simplified approximate numbers for Dropbox. At year end in 2019 is had long-tern debt of $138.2 and the book value of its equity was $808.4 million. So, the figure for CAP at that point was $946.6 million. At year end 2022 the company is showing long-term debt of $1.525 million and equity of negative $309.4 million. So, the financial statement figure for CAP was $1,216.

The figure for CAP is in the same ballpark from one period to the other. So, the ratio of FCF/CAP remains steady. But the company’s balance sheet has changed fundamentally. It seems the company went out and borrowed something like $1.5 billion and bought back shares. One might ask, why would a company in a solid financial position borrow money and put itself into negative equity? If you don’t understand this you might read my post: The emergence of a new model of capitalism

It is useful to compare Dropbox’s book value of equity, negative $309.4 million, with the price the stock market puts on its equity $9.5 billion, i.e. Market Capitalization or Market CAP. If we accept that the stock price very roughly indicates the value of the equity, the company has about $9 or $10 billion of intangible assets.

What does all this mean?

Companies that produce a high return on capital are of special interest. They may just be the kind of company that “over an extended period can employ large amounts of incremental capital at very high rates of return”, to use Warren Buffett’s phrase.

In this day and age, both reported income and capital have been distorted by the shift of companies to invest in intangibles of lasting value. Company investment in tangible assets is not a company expense. It gets capitalized and appears on the balance sheet as an asset and depreciated. Company investment in intangibles of lasting value is almost always expensed. This reduces current reported income. But the intangible assets produced do not appear on the balance sheet. It seems Dropbox may have intangible assets in the order of $10 billion.

The use of balance sheet numbers for CAP can be misleading. The market is telling us that the company is employing debt capital of some $1,525 million and equity capital of some $9 billion. On that basis its CAP is about $10,525 billion. Viewed this way it’s FCF/CAP for 2022 is more like 7.24% rather than the 19.2% shown on the screen.

Conclusion

I make no judgement about Dropbox. I am very interested to identify companies that not only produce serious incremental capital but also can employ that capital at very high rates of return. It is a mistake to take FCF/CAP at face value. Because the reported net income of companies making substantial investment in intangibles of lasting value is distorted, free cash flow offers a good way to look at whether these companies can produce high rates of return on their capital. But it needs to be done with thought about what the numbers for FCF and CAP really mean.

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You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith

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