Free Cash Flow Plus Growth: Isn’t It Just Double Counting?
Someone emailed me this question:
I have the following quote from the article How Much is Too Much to Pay for a Great Business, “For example, let’s say I buy a stock with a 15% free cash flow yield and 3% growth. I make 18% a year while I hold it”.
And a similar quote from Terry Smith, “If the free cash flow yield is 4% and the company is growing at 10% per annum, your return, if all else remains equal will be 14%”.
There’s a number of other great investors who have said similar things. But running the math, there must be something obvious I’m missing.
Is that not double counting? Assuming no multiple rerating and no dividend, isn’t the return the growth alone?
Yes, you are correct if instead of “free cash flow” the thing you are counting is “earnings” and earnings retention is 100%. That is, there is no dividend and no share buybacks and no acquisitions and 100% of earnings are being retained to grow the business organically. In such a case, the reported earnings would increase balance sheet items such as inventory, receivables, property plant and equipment, etc. and there would actually be no “free cash flow”.
For an example of what I mean, see IEH Corporation (IEHC). This is a fairly good example of a company that for the last 10 years or so has delivered growth in the business that is quite high (revenue grew 10% a year, EPS grew 9% a year) without delivering any real free cash flow. The business came pretty close to retaining 100% of generated earnings in the form of additional inventory, etc. Here, the return is the growth. No need to discuss free cash flow.
The extreme example on the other side would be something like OTCMarkets (OTCM). I usually use this one as the example to illustrate the idea of free cash flow plus growth because it comes closest to the idea of growth being “costless” in the sense that you do not need to retain earnings at that company in the form of additional inventory, receivables, etc. to drive growth in the size of the business. Basically, the company could theoretically pay out all reported earnings as a dividend and still grow each year. Note, however, that it does not actually do this. Instead it builds up cash on its balance sheet.
But, if we compare OTCM and IEHC – by growth, they are pretty similar. OTCM grew sales by 13% a year and EPS by 19% a year vs. 10% and 9% at IEHC. So, yes, OTCM was faster growth. But, the big difference is in free cash flow. At OTCM, free cash flow was actually higher than reported after-tax earnings while at IEHC free cash flow was about 90% lower than reported earnings (because it did not have “cash” earnings while growing – the earnings all went into non-cash balance sheet items like inventory and receivables).
This is a critical …
Read more