Why Do You Sometimes Price a Stock Off of Its Free Cash Flow Yield Plus Growth Rate Instead of Just Using its P/E Ratio?
Someone sent Geoff this email:
Dear Geoff,
In this video you mention a PE of 26 for OTC and yet use an implicit growth rate of 6% which is not the inverse of 26. I would like to understand why that is.
Answer: If a Company Converts 100% or More of Its Earnings Into Free Cash Flow While Also Growing – a Normal P/E Ratio Would Deeply Undervalue the Stock
I’d assume it’s because 10% = (1/26) + 6%
In other words…
10% – 6% = 4%
And 1/25 (not 26) is 4%
OTCMarkets is unusual. What matters for a stock isn’t actually earnings – it’s truly free cash flow. So, a stock that retains 100% of its earnings and grows 6% a year while doing that still isn’t worth more than many stocks growing 0% and paying all earnings out.
Some stocks – OTCMarkets is one – have a lot of “float”. As a result, they are capable of paying out 100% (actually more than 100% while they are growing) of their earnings in dividends and buybacks while growing. They don’t actually have to retain earnings. You can see that with OTCM. The asset that has grown over time is cash. A tip-off to this fact is that ROIC is often calculated as being very high, infinite, or even negative by some websites (a negative ROIC means that the company’s cash balance is greater than what it has actually invested in the business in stuff like PP&E, receivables, inventory, etc.).
So, my point is that if OTCMarkets grows by 6% a year and you need a 10% return as your discount rate…
Well, OTCMarkets can grows at 6% a year AND pay a 4% a year dividend yield if priced at 25 times P/E.
Note that OTCM does not actually pay such a high dividend though. So, it’s somewhat debatable what the stock is worth if management keeps cash on the balance sheet rather than using all FCF to buy back stock and pay dividends.
For comparison, look at Omnicom (OMC). It actually does pay out dividends and buy back stock equal to at least 100% of reported earnings. So, the calculation there is simple. Assume OMC grows at 0%. Assume your discount rate is 10%. What is the correct price for OMC?
It’s a 10x P/E. Because OMC at 10 times EPS, OMC will pay you dividends and buy back stock equal to 1/10th of your purchase price. What this will actually do is make EPS grow – even when the company’s actual earnings don’t grow, just because share count is falling – plus you get the dividend. If the combination of the dividend and the EPS growth equals 10%, you’ve hit your hurdle rate.
So, what I said about OTCM is somewhat unique to that company and other business models like it, generally:
– Ad agencies
– Subscription services
– Some software companies
– Etc.
Usually, you have to be doing something fairly intangible (you can’t be a manufacturer or retailer) and you have to be collecting payments from customers (these are usually subscriptions) before you provide services to them. Your customer has to “pay ahead” for the next year, quarter, month, or week before you actually deliver the good or provide the service.
When these conditions are met, you get float.
It’s similar to an insurer. A company like OTCM is worth current FCF yield PLUS Growth Likewise, an insurer is worth BOTH the money made from underwriting and the investment income earned on its float.
It’s the same concept. This makes P/E comparison between industries difficult.
A railroad with a P/E of 25 would be very expensive whereas OTCM with a P/E of 25 might be cheap.
Why?
A lot of the railroad’s reported earnings must be used on cap-ex. On a net basis, none of OTCM’s earnings go back into reinvestment. This is due to different FCF conversion rates. Railroads convert EPS to FCF very poorly – especially while growing. Companies like OTC convert EPS to FCF very well – especially while growing. In fact, the faster a capital intensive business grows, the worse conversion of EPS to FCF becomes. Meanwhile, the faster a float generating business grows, the better conversion of EPS to FCF becomes.
Where I said “P/E” you could just substitute Price/Free Cash Flow to be accurate.
With OTCM, I just make the assumption that any one year’s earnings per share is an UNDERESTIMATE of actual FCF.
Over the last 10 years, OTCMarkets has actually had – cumulatively – 30% more free cash flow than earnings. So, in reality EPS/1.3 = 0.77x free cash flow. In other words, when I use P/E instead of Price/Free Cash Flow I am likely underestimating OTCM’s cash earnings for the year by about 23%. Let’s call that 20%. If it grows slower in the future, that might change.
So, a P/E of 26 is really more like 26*0.8 = 20.8; Call it 21 times earnings. Call a P/E of 25 really a Price/Free Cash Flow of about 20.
In reality, if OTCMarkets is priced at a P/E of 25, that’s really like having a free cash flow yield of 5% (because Price/Free Cash Flow is likely 20 instead of 25).
That means if my hurdle rate is 10% total, I really only need OTCM to grow by 5% a year while I own it.
10% – 5% Free Cash Flow Yield = 5% Required Growth
So, starting at a P/E of 25 – OTCMarkets will probably beat the market over time if it grows faster than 5% a year.
I try to be a little conservative in my assumptions. Remember, the problem with growth rates is that they do tend to slow down over time. Maybe OTCM is such a great business it can grow 4-6% a year forever (I could believe that). But, no business is so great it could grow 10% a year literally forever. Maybe for the next decade. Maybe for the decade after that. But, eventually analysts will add a lower “terminal” growth rate to their DCF.
That isn’t how I value companies. I only look at 10 years when analyzing a stock. So, when relying on stuff I say about a stock’s value in the future – you need be extra careful to make sure that a growth rate I refer to is sustainable over the next 10 years and that at the end of those 10 years investors are likely to still be expecting the same growth for the next several years (otherwise, the P/E multiple would contract).
Most importantly, keep in mind that it’s free cash flow rather than reported earnings that matter. Your return in a stock depends on a combo of growth and free cash flow. If there’s no free cash flow now – you need more growth. If there’s no growth now – you need more free cash flow. A P/E ratio approach is often too simplistic. That’s especially true when comparing stocks in different industries.
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