Why Free Cash Flow is a great fundamental indicator

How much cash a company can generate is one of the more important measures of its health.
By Morningstar Analysts |  04-11-16 | 
 

In a post that appeared on Morningstar Canada, William Booth, managing director and senior research analyst at New York-based Epoch Investment Partners Inc., speaks of the importance of cash flow.

When analyzing stocks, Booth focuses not so much on conventional measures such as price-earnings multiples, but on a company's ability to generate free cash flow. Consequently, at the heart of his analytical process lies the ability to grow free cash flow over time and the management's allocation of capital.

According to him, the ability of management to allocate cash flow properly determines whether the value of the business will rise or fall. If a company can invest that cash flow, either internally or externally, and generate a marginal return on invested capital that exceeds the marginal cost of capital, then making that investment will increase the value of the business.

And what can management do with free cash flow? Booth cites five options (which the firm graphically presents below):

  • Pay a cash dividend
  • Buy back stock
  • Pay down debt
  • Make an acquisition
  • Invest internally, in research and development for instance.

free cash flow

The firms two CIO’s – William Priest and David Pearl, in an interview with Barrons delved on the same issue. Priest said that the first question he asks a company is: “How do you allocate capital?” If they say, “We’re a growth company; we reinvest every dollar internally,” that’s a very bad answer.

A better answer would be, “We think our cost of capital is 4%, 6%, 7%, 9%… To that we add 800 basis points [8%], and arrive at a hurdle rate for reinvestment. We will reinvest or acquire down to that number. Anything in excess of that -- what we don’t need for working capital -- we return to shareholders.”

Saying that does not necessarily mean a company is any good at it, but it does point to the fact that they have a sensible methodology.

Pearl explained that if you only buy companies that generate cash, they never go bankrupt -- even during a financial crisis.

There is sound logic behind why Epoch’s security selection process is focused on free-cash-flow metrics as opposed to traditional accounting-based metrics such as price-to-book value and price-to-earnings ratios. Earnings growth and dividends drive shareholder returns, and they come from a single source - cash flow. Hence the focus on companies that are growing free cash flow and allocating it intelligently.

The investing philosophy favours reinvesting cash flows in internal projects or acquisitions only when those actions generate returns above the cost of capital. Otherwise, they are of the opinion that company managements should return excess cash to shareholders through dividends, share buybacks or debt repayments -- collectively known as "shareholder yield."

In conclusion…

At its most basic level, free cash flow, or FCF, can be calculated as operating cash flow minus capital expenditures: FCF = Cash flow from operations - capital expenditure

Investors must use this measure to identify companies with a consistent ability to both generate free cash flow and to allocate it intelligently. Observe free cash flow over a period of a few years rather than a single year or quarter.

No one is saying that this is the only parameter to follow, but by employing it, investors can at least eliminate most bad investments.

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