The Power of Free Cash Flow

Often, what is value creation? It is the magic of an entrepreneurial mind and a commercially-viable business idea, mixed with the ability of creating products/services that consumers desire. We measure that by a business’ free cash flow generation ability.

Free cash flow (FCF) is simply “cash flow from operations MINUS capex”

FCF allows a company to (1) pay down debt (2) buy-back shares (3) reinvest in operations or (4) perform strategic M&A activities. FCF is extra after paying for everything.

As all of us are acutely aware, cash flow is the lifeline of any business and we should never look at earnings alone. When a company makes an accounting profit, but the money is not received…. is it a good business? The cash flow is nil because the sales were made in credit. Essentially, the trade receivables are not converted into cash flow yet.

When the cash takes too long to be collected and a business is required to make immediate payments on its expenses, it spells big trouble for the company. That is why I skip companies with long receivable days.

Let’s go one step further.

Different Types of Capex

Companies do spend on extra items to grow their business or maintain its competitive advantages. For that to happen, businesses spend on something called capital expenditure (capex).

For plane operators, their planes do have wear and tear. The planes are required to be replaced every few years. Typically, the life span of a plane is 20 years depending on the intensity of usage.

There are growth capex and maintenance capex. What are the differences?

For a plane company:

• When new planes are purchased to replace old planes, that is called maintenance capex.
• When new planes are purchased to support new routes, that is called growth capex.

For a manufacturing company:

• When new machines are purchased to replace old machines, that is called maintenance capex.
• When a new factory is built, that is called growth capex.

For more deeper understanding, you can visit this article from Gurufocus.

Profits Do Not Create Value

Profits do not create value. Free cash flow creates value because that is ultimate cash profits a business retains after paying for opex and capex (ongoing business requirements). This is the ultimate value added to the business.

To illustrate the point across, let’s use two companies called Capex Monster versus Mini-Capex.

Clearly, you can see revenue size has got nothing to do with the capex requirement of the business. Despite CM earning $100m cash flow, its residual free cash flow is nothing. For MC, its cash flow was much smaller at $20m but its residual free cash flow was $15m. At the end of the day, if you ask me which company is more valuable, I will vote for Mini-Capex (MC). I cannot value CM at all.

Size is Not Important; the Free Cash Flow is Important.

Why? Because companies that can generate immense free cash flow tends to enjoy higher price multiple valuations (and rightfully so!). These businesses generate tons of excess cash flow!

However, there could be many reasons why CM was spending so much capex. Maybe they were building a new factory to support business expansion. Let’s say, $50m out of the $100mil was growth capex. We will normalise the capex.

It’ll not look so bad after all! On top of calculating the free cash flow, we need to understand the capex spending plans of the company to normalise it well.

Asset-light industries tend to generate more free cash flow than asset-heavy industries. It also explains why one industry enjoys higher valuations. For asset-heavy companies where their capex = cash flow from ops, it is hard to value such companies. Ideally, one should not spend the effort to research on it. Essentially, these companies had grown bigger over the years, their value remained stagnant.

Case Study examples (Singapore Airlines and Visa)

(screen grab from Google Finance)

In this scenario, an investor would have earned 13.56% returns holding the stock for 9 years. Is that surprising? After understanding the concept of free cash flow, you would understand.

Make no mistake, I love Singapore Airlines as a customer. They are doing a great job and their service level is superb. This is just an example to show the capex needs of the airline industry.

This is great! The company is making tons of net profits and the cash flow is even stronger than its net profit. A very good sign. But wait… how about its capex?

(figures sourced from annual reports, there are some data errors on Morningstar.com)

You could see that, out 5 years, there was only one year that generated free cash flow. Most of its cash flow generated were returned to support the business and minimum free cash flow is available for the owners of the company. There is no shareholder value created. Ok, let’s move over to look at Visa.

(screen grab from Google Finance)

Visa’s share price appreciated more than >600% within the timeframe.

You can see this is because of Visa’s superior free cash flow generation ability. Visa is an asset-light company. The enormous amount of free cash flow allowed the management to pursue share buy-back to enhance shareholder value among other activities.

Free cash flow compilation of quotes from ValueWalk:

“Cash flow, not reported earnings, is what determines long-term value” William Thorndike

“Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow”  Michael Mauboussin

“The most important metric we look at is probably Enterprise Value to free cash flow” Eric Rosenfeld

“Ultimately, in one form or another, cash flow is all companies have to distribute to investors, and cash flow is the only thing investors can spend.  Ultimately, investment success depends on how much an investor pays for the cash flow a company generates.” Andy Redleaf

Summary

• Free cash flow = cashflow from operations minus capex.
• Go for companies with strong free cash flow generation abilities.
• Find out whether the capex spending is temporary or permanent by differentiating growth and maintenance capex.

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