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Strategies & Market Trends : Value Investing

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To: sjemmeri who wrote (11792)	1/10/2001 11:37:23 PM
From: James Clarke	Read Replies (1) of 78483

The reason free cash flow is so much a part of my analysis is that it is real. You can't buy a pizza with GAAP earnings. Where it is most valuable in analysis is when free cash flow doesn't match earnings. Xerox and Armstrong World come to mind there. Negative free cash flow was a huge warning flag which was there for anybody to see long before the stocks collapsed. Earnings are not always in cash, and it will save you from a lot of mistakes to understand why and to check that before buying a low P/E stock. A company with free cash flow has options that a company without free cash flow doesn't. They can buy back stock. They can pay down debt. They can bottom fish and acquire competitors on the cheap. An important warning. Free cash flow numbers that come through screens or Yahoo or similar databases are notoriously wrong. Sometimes I wonder where they're getting their numbers. I firmly believe that you've got to do the calculation yourself. I own one company with a roughly $100 million market cap which generates $30 million of free cash flow per year. I own another with a $170 million market cap which generates about $35 million. I don't worry much about these - I just check the cash flow statement once a quarter and wait for them to double. As for valuation, there's no formula, just judgement. I like to take the inverse of the free cash flow multiple to make me think like an owner. Rather than saying the stock trades at 12 times free cash flow, I think in terms of an 8% free cash flow yield. i.e. if I owned this whole business I could put 8% in my pocket in year one and not harm the franchise. For some companies 5% might be enough, for others I might require 10 or 12%. Unless that free cash flow is obviously a peak number that will never be repeated again, I rarely require more than 10% yield. And that usually provides a good deal of downside protection because at 10% the company can buy back a lot of stock and makes an obvious takeover target. And then we have Apple, which somebody asked about. Here is one where a very simple cash based analysis comes together beautifully. $17 stock price, $11 of cash. So you're paying $6 for the business. It generated approximately $2 a share of free cash flow each of the last three years. Obviously they hit a rough spot, and I have no idea how long that will last. But the stock is just too cheap. I just think we have a case here where the people who bought the stock at 60 had no comprehension of valuation, and now they're selling at this level having lost a lot of money and demonstrating that they learned absolutely nothing from the experience.

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