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Strategies & Market Trends : Gorilla and King Portfolio Candidates
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To: Uncle Frank who wrote (49286)11/30/2001 11:54:38 AM
From: Pirah Naman  Read Replies (1) of 54805
 
uf:

So you're saying that if they spend a buck of the retained $7 to buy a new factory, it would reduce the value of the company?

No. What Ethan is saying is that if they spent a buck on the factory, it is not available for owners. FCF is the money available after the company has bought the new factories it needs to grow the business. It is truly discretionary. They've invested all they could in ventures where they have expectations of a high return, and then they still have money left over. (John Shannon explained the accounting quite succinctly.)

Take a look at the Silverbacks. How did they come to have such huge piles of cash? By taking in more cash than they spent, over a prolongued period. Apparently they don't see where they could invest more in ventures that would give them a high return.

Now what they do with that FCF is something you can look at in gauging management's rationality. Do they pay a dividend? Reduce debt? Buyback shares? (The latter two will result in increased profits per share.) Or will they invest in a less profitable or less certain venture? Will they get lax on some other costs, e.g. compensation?

Thomas' point about the maturity of the company is a good one. If we are looking at "mere" candidates in tornado, we don't expect them to be generating tons of free cash flow. For a young gorilla, we might reasonably expect them to generate some decent free cash flow in the forseeable future. We expect very good free cash flow from a silverback. So this all ties in to what I wrote before about setting expectations. Maybe an investor wants to work with time (company should be modestly free cash flow positive within 5 years) or base it on sales (company must be modestly free cash flow positive at $1B revs), or even just work in terms of TALC. But it makes sense to set some expectations about financial performance. It reflects on their business performance, and it is ultimately what we as owners seek. That is underlying why we look for companies that will become silverbacks - that long stream of FCFs.

All of the above only relates to evaluating a company's strength and performance. Not valuation. Valuation is based on the future stream of free cash flows, not the past. A company can be generating huge amounts of free cash flow and still be overpriced; another might be FCF marginal or even negative, but be underpriced, if its future profitabilty is underestimated.

- Pirah
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