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 distinction. You must not add earnings and earnings growth together to get your potential “hold” return in a stock. For most companies, a very large amount of reported earnings have to be retained to fund the growth.
For example, during the 20th century, Dow Jones companies in the U.S. basically grew in sales, earnings per share, etc. by about 6% a year while paying out a dividend of about half of reported earnings. This means the return in the stock would be expected to look something like 0.5x earnings yield plus growth. The 0.5x vs. 1x is a big difference. If all reported earnings had instead been actual free cash flow and growth had been the same, I would estimate that returns in the Dow would be like 12% a year instead of closer to 9% a year during that century.
Let’s use Vertu (VTU) as an example.
Notice that when I mention the P/E ratio of Vertu or its earnings yield, I don’t ever talk about earnings yield plus growth at Vertu. This is because a lot of any growth at Vertu would come in the form of additional dealerships, cars, etc. So, it’s really just cash build, stock buybacks, and dividend yield combined that give us an idea of the company’s actual cash return to investors (free cash flow).
Maybe the easiest way to look at this is to take the calculation you did and assume it applies to a bond instead of a stock.
If a bond yields 6% a year and you buy it to yield 6% a year and it stays yielding 6% a year – do you get a return?
Yes and no.
There’s no capital gain. You bought it to yield 6% and it stayed selling at par, so it was yielding 6% when you sold it.
But, in your illustration, what happens to the bond’s yield. The actual interest payment disappears in your example. This is obvious when I apply it to bonds, but less obvious when I apply it to stocks.
Where does the free cash flow yield go?
That’s what matters. The free cash flow plus growth works pretty easily if we imagine 100% of free cash flow is paid as a dividend. In that case, the stock becomes like a bond and the return is obvious. We get the growth plus we get our annual dividend. Capital gain is the growth. Income is the yield.
But, what if the free cash flow is used to buyback stock. Then, it gets more complicated. If the stock is underpriced, we actually get an even better return over time than if we were paid a dividend. If the stock is overpriced, we get a worse return.
What if the free cash flow is used to pile up cash?
This is a really tricky question. There’s no good answer. Basically, piling up cash just puts off the eventual decision of what to do with the cash. Eventually, it has to be used to pay dividends or buy back stock or acquire something. We’re just unsure when that will be and what the payoff from it will be.
What if the free cash flow is used to retire debt?
The return here depends on the cost of the debt. If the company was borrowing at 5% a year – this is probably a bad use of free cash flow (paying down the debt) and will add less than $1 of market value to the stock for every $1 of free cash flow produced and used to retire debt. That’s because the company was paying 5% pre-tax which is only about 4% after-tax (in the U.S). And, so, it’s as of the company took that $1 of free cash flow and “invested it” at a 4% return. Since shareholders can do better than 4% a year in a variety of other investments – that $1 of free cash flow has been solidified by a decision that’s made it worth less than $1 for shareholders.
In theory, the closest thing to a neutral use of cash would be a dividend. In the U.S., you pay taxes on this. So, the immediate tax hit is actually a negative vs. deferring it and investing in something else (an acquisition, etc.) that has the same return the dividend recipient can get on his own money. However, putting that aside, it’s pretty close to neutral to say we can benchmark any use of free cash flow against its use as a dividend. A dividend of $1 is the sort of neutral neither value destroying nor value adding way of benchmarking $1 of free cash flow. All other uses of free cash flow will be better, worse, or about the same as paying it out as a dividend.
This is why I sometimes mention Warren Buffett’s “market value” test. OTCM retains its “float” as cash and does not invest the float in long-term bonds, stocks, etc. the way an insurance company would. As a result, this is free cash flow – but, is it worth much? Well, it offsets the need for debt certainly. The company isn’t going to borrow cash it already has on hand. And if interest rates rise much higher, you’ll start to notice some interest income earned on idle cash on the balance sheet even in cases like OTCM where they aren’t intentionally investing it. It’s like cash in the bank basically.
For your thinking about free cash flow – I’d suggest tracking the flow in your mind. This will probably help you see what is happening at a company and whether the free cash flow is adding value and how it adds value. Certainly, it does add value. I mean, any stock with a high free cash flow yield that is maintained for even a few years will have a major impact on the stock price eventually even if management does little or nothing with the free cash flow. For example, a stock with a 15% free cash flow yield that is retained for 6-7 years would end up with an enterprise value of zero (more cash than market cap) unless the stock price rose somewhat to account for the turning of these free cash “flows” into cash “stocks”.
This concept of a “flow” vs. a “stock” might also help understand the idea. Free cash flow has to “go” somewhere. It can’t just disappear (as it does in your illustration). Ultimately, it has to become cash on the balance sheet. If not: where did it go?
Well, it was paid out to shareholders as a dividend. In that case, it adds to your annual return and the free cash flow plus growth idea works. Or maybe it is used to buyback stock. Again, the “flow” of cash becomes a “stock” of retired shares. The company has bought back some of its shares outstanding. This makes each share left worth more, increasing earnings per share growth, etc. Again, the idea of free cash flow plus growth works. Say you have a 15% free cash flow yield and 5% growth. Okay. Now, the 15% free cash flow yield is 100% used to buy back stock. It disappears. But, do the continuing shareholders get value for it? Yes. Now, the company – on a PER SHARE basis – seems to be growing faster than 20% a year (5% growth overall and only 0.85x shares left over this year is the same as if growth was 23-24% and shares stayed the same — 1.05/0.85 = 1.24).
Your point is valid in the very narrow situation in which somehow the free cash flow is used so poorly and Buffett’s “market value test” failed so badly that the company is using its free cash flow in a way that drives zero gain in the stock price. This is harder to do than it seems. If a dividend is paid, shareholders get the dividend less taxes. If a buyback happens, the P/FCF multiple would actually have to contract fully to offset the gains from the buyback for the free cash flow not to count as your eventual gain as a shareholder. Likewise, it’s possible the market could keep the same Market Cap / FCF ratio the whole time you owned the stock – but, this would require the EV/FCF to contract as cash built up on the balance sheet.
The easiest way to have free cash flow not benefit you would be bad acquisitions that add literally no value. Unless these acquisitions are super speculative, start-up, diworsifying, etc. type deals – it’s hard to imagine they could add zero dollars. Even a really bad use of $1 per share in free cash flow to purchase a new company would likely add $0.50 a share of value to the stock rather than literally zero dollars of value. For example, even if the company trades at 15x FCF and always buys companies at 30x FCF, the acquisitions would still cause $1 of free cash flow used on a merger to add $0.50 of value to the stock’s price. This assumes the P/FCF multiple is always 15x.
Basically, you have to account for where the free cash flow goes. You can’t pretend it just disappears. It has to result in lower debt, fewer shares outstanding, dividend payments made to shareholders, businesses acquired, or cash on the balance sheet. And, eventually, all of these “stocks” of assets have to solidify the original free cash flow into something the market puts some positive value on.