Investing for Free Cash Flow

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

-Scott McNealy, Sun Microsystems CEO, speaking of the share price in 2000.

Today, many U.S. stocks, particularly in the technology sector, are trading at 10 times revenue or higher valuations. Historically, valuations this high have been unsustainable, and it’s helpful to remember this lesson from the dot com bubble 20 years ago. Sun Microsystems’ shares didn’t trade at $64 for very long, but declined to $5 over the next two years before the company was finally acquired by Oracle at $9.50 per share in April 2009.

Valuation matters because the higher it is, the harder it is for an investor to earn attractive returns. There are many different ways of looking at valuation, often people look at revenue or earnings, but free cash flow is more important because it’s the cash that can actually be taken out after all expenses are paid, particularly capital expenditures, that determines what a business is worth, if anything, assuming you’ve potentially got high uncertainty in asset liquidation value.

GAAP (generally accepted accounting principles) are used for tax purposes where revenues and expenses are matched up in time. Depreciation could be amortized or front-loaded. If the actual cash flows differ greatly in timing relative to the GAAP recognition of the associated revenue and expenses, or accruals, it is possible for a project to look attractive under GAAP accounting but be value-destroying under a cash flow analysis.

Consider the following example where a company builds a $10 million factory that will generate $2.5 million of sales per year, with $800,000 of labor costs and $400,000 of material costs. The net income is discounted at a 5% rate. Under a GAAP accounting framework where the cost of the factory is amortized evenly over 10 years, the project looks profitable (see Table 1), while in cash flow reality, the whole $10 million cost of the factory goes out at the beginning of year 1, so from this perspective the project is unprofitable (Table 2). This is important to realize because managers often rely on the GAAP accounting view, approving projects that destroy value, being compensated to do so based on corporate earnings, not cash flows.

Source: Epoch Investment Partners

Now, if this business was a service business or other asset-light business that could grow sales without investing more in labor or materials, the numbers could improve a lot over the 10-year period. This is often a source of inefficiency in how companies are valued. Businesses that can get more valuable without much marginal investment are immensely more valuable than those that can’t.

Free cash flow yield and growth are helpful for predicting returns of stocks. To evaluate this idea, indexes of stocks were sorted by free cash flow yield over a 26-year period at monthly intervals. The stock indexes were normalized by industry group and country as well to control for events that might have an outsized effect on a particular industry or country. After sorting and normalizing, the indexes were separated into five quintiles and the annualized return of each quintile was calculated based on historical data.

Higher free cash flow yields result in impressively higher returns and lower volatility over the whole 26-year period. However, examining the year by year performance, you will notice that there are multiyear periods where higher free cash flow quintiles underperform and a long period since the 2008 financial crisis where higher free cash flow quintiles have not resulted in more cumulative outperformance. Sometimes you can have extreme growth/momentum outperformance as in the late 1990s tech bubble as you do now, but this behavior historically reverts toward long-term averages. The 2007–2008 period underperformance was due to banks trading cheaply, and deservedly so, as a result of their problematic balance sheets. More recently, the low interest rates, and extreme monetary policy have created distortions resulting in strong performance of less profitable, more indebted companies and a wider range of perceived fair valuations of rapidly growing companies. As interest rates get marginally closer to zero, one can justify higher valuations approaching infinity in a discounted cash flow model.

Free cash flow yield is a more significant variable affecting equity returns in the small cap Russell 2000 index, probably because these companies can grow more on average than larger companies and the dispersion in how profitable or unprofitable (or headed toward bankruptcy or oblivion) they can be is much wider.

There is some outperformance from higher free cash flow growth quintiles, but the results are uneven because free cash flow growth doesn’t tell you anything about the valuation. The weakest quintiles don’t produce good returns, unsurprisingly. The highest quintile, however, doesn’t do as well as quintiles 2 and 3, likely because there is excessive enthusiasm for and resulting overvaluation of the fastest growing companies. The best cumulative returns are had by those that don’t grow as quickly, but are perhaps overlooked and undervalued. The fact that quintiles 2 and 3 tended to outperform during difficult periods for the market and free cash flow yield in general in the wake of the 2000 tech bubble and 2008 financial crisis supports this view.

Among smaller companies in the Russell 2000, free cash flow growth is a better indicator, likely because it is harder for market participants to ascertain the growth runways of smaller faster growing companies, and perhaps that they have not been too closely examined by too many participants to depress the returns of the fastest growing companies as has happened in the large cap Russell 1000, at least historically from time to time.

Similar results are found globally in the MSCI World index.

While the insights from studies like this are interesting and important, it is equally important to remember that over shorter periods of time, sometimes two to five years or longer, Mr. Market can behave erratically, out-of-sync with long-term average expectations.

1. William W. Priest, David N. Pearl, and Steven D. Bleiberg, “Free Cash Flow Works.” Epoch Investment Partners white paper, October 6, 2016.
2. Qing Li and Aye Soe, “Incorporating Free Cash Flow Yield in Dividend Analysis.” S&P Dow Jones white paper, November 2017.

*This article is for informational purposes only and should not be considered investment advice.