It is all about free cash flow

Let's get the shareholder value roadmap right

I want to start by thanking all my new subscribers. It has been overwhelming to see the interest in this publication. I will do everything I can to honor this interest with thoughtful perspectives on equity investing. With that said, let us dive into today’s topic of free cash flow.

Equity valuation starts with free cash flow

All future posts will only make sense if I start by defining how equity valuation works. Many think it is mysterious and some even think that equity valuation is a hoax.

Let’s start with the shareholder value roadmap. How is shareholder value generated? It all starts with sales growth. A company then deducts operating expenses which leads to an operating margin and operating profit/loss. It also has to pay taxes on these operating profits which leads to net operating profit after taxes (NOPAT). In order to grow, the company does incremental investments in working capital (the capital needed to run the daily business), fixed capital (equipment, property, R&D, and branding), and finally it can acquire other companies. NOPAT less investments equals free cash flow. These free cash flows in the future are discounted at the cost of capital to determine what is called the corporate value. The investor must then add non-operating assets and subtract non-operating liabilities (interest-bearing debt and certain liabilities). Finally, the investor must adjust for any stock-based compensation (stock options, warrants, restricted stock units etc.) to arrive at the shareholder value per share.

I have created a small example to showcase the free cash flow calculation without all the details. This example will be expanded in the next post. The calculation shows a hypothetical software company growing sales 16% one year with a 25% operating margin and cash tax rate of 12%. Because the company operates in the software industry its incremental working capital is only 5% to sales growth ($160 x 5% = $8) which means that in order to grow sales by $160 (16% growth) it must increase its net working capital (current operating assets less current operating liabilities). The company has a 20% incremental investment rate in fixed capital driven by research and development costs. Next time we will show how we go from free cash flow to shareholder value.

There are many nuances in equity valuation that I will not explain today. These are mostly around separating operating cash flow and the balance sheet into operating and non-operating parts by reconstructing financial statements. We have also not touched on the return on invested capital (ROIC) and how the dynamics work in the key value drivers of a company. Later, when all these concepts have been explained we will move into the realm of business strategy. I will also present my idea of how Warren Buffett and Charlie Munger have linked the free cash flow framework into their decision making without making large spreadsheets with numbers. I think the crucial link is Charlie Munger’s idea of “always invert” as his mental model, but more on that in the future.

Later this week, I will take the free cash flow framework and apply it to a hypothetical software company that has significantly increased its incremental fixed-capital investments to join the race for AI leadership. I will show the dynamics of increased capital intensity and how it flows through equity valuations. In the context of the current AI investment boom and equity concentration in the ‘Magnificent 7’ this understanding is crucial for investors.

Let’s fix the ‘tools’ in active management

The recent research from Apollo showing that Roughly 90% of Active Equity Fund Managers Underperform Their Index over a 10-year period has got a lot of attention. Something is clearly broken in active management. It cannot be better than 50/50 before transaction costs, but 10/90 in favour of the index is surely a catastrophe for the active management industry.

Michael Mauboussin highlights four reasons in his book Expectations Investing for why active managers are failing:

1. Tools - many investors are still widely using “price-earnings” multiples and focus on earnings per share (EPS) trends and EPS figures vs analyst expectations every quarter. A lot of future publications will convince my readers that if we want to invest in equities we must think differently.

2. Costs - active equity funds are at least seven times above passive index funds in the US adding significant headwinds. The active management industry is still trapped in the old paradigm of high fixed fees for management of assets instead of low fixed fees and instead get paid predominately for performance above the benchmark. I recently came across a Danish UCITS global equity fund with a fixed fee of 2.29% of assets under management. I will claim that the software tools available today make a portfolio manager significantly more productive and thus fixed fees should reflect this. Get paid for performance. It is a bit like musicians. They have been forced by streaming services to give up the fat pay from royalties and instead earn their living from stage performances.

3. Incentives - too many managers focus on lowering the tracking error because high tracking error increases the likelihood of an extended period of underperformance against the benchmark. This is the main ingredient of a portfolio manager getting fired. So some portfolio managers will add the largest stocks in an index to the portfolio to limit the tracking error and not because they necessarily see any added value in the underlying security. This behavior is odd given research shows that high active share (deviations from the underlying benchmark) is correlated with positive excess performance over the benchmark. The problem is that many asset management firms apply the fixed fee model and not pay for performance which leads to the wrong incentive structure for the portfolio manager which then minimize the tracking error leading to lower probability of outperforming.

4. Style limitations - humans lust for using labels such as ‘growth’ and ‘value’ etc., have done more harm than good for portfolio managers. These labels constrain portfolio managers. Just ask any value manager in the past 10 years. As the free cash flow framework shows growth is just a component of equity valuation. It is not a distinct strategy.

I will explain the cure for active management in a later post, but for now understand that the premise for success in equity investing requires 1) using a free cash flow framework, 2) charge low fixed fees and high incentive fees, 3) avoiding the tracking error trap, and 4) be as unconstrained as possible.

Capital return is not a value driver

I came across on LinkedIn an investor explaining that one of the main reasons why Apple had seen strong share price gains over the past many years was its almost $1 trillion of buybacks and dividends. This is one of the fallacies that we must add to the graveyard of mistakes in equity investing.

Buybacks and dividends are just management decisions regarding free cash flow. If management decides that its free cash flow exceeds the available investment opportunities it will often choose to pay it out to shareholders. This decision, in itself, does not drive any value. These payouts only happen because of positive free cash flow, so in terms of causality it is free cash flow that drives equity valuation. Payouts to shareholders are simply a residual of free cash flows.

The obsession with buybacks is linked to the P/E multiples and focus on EPS as buybacks lift EPS and then when applying a P/E multiple then the share price goes up. So many think that buybacks add value. They rarely do. They are often used to manage EPS or offset the EPS dilution from stock-based compensation. Sometimes a buyback signals that the company is undervalued, but that is rarely the case and in the current period with high equity valuations that is most likely not the case. If anything, buybacks and dividends will often signal a slowdown in growth ahead because management is finding it hard to find investment opportunities.