Free Cash Flow, Where's the Money Go?
A humble thank you to all that told me in PM or on the thread that more discussion was desired. I really appreciate it.
At first, I did think that valuation discussion was a bit OT. But upon further thought, valuation of companies using free cash flow is very on topic. I believe the book supports this. This is going by memory, but nowhere does the book suggest that investors underestimate how much other investors will pay for a company's stock at some future time. The fundamental premise is rather that investors underestimate the earnings power of a gorilla. As the authors define the value of a company very similarly to how I define the value of a company, it is worth trying to estimate that value.
To that end, I ask again that those who found the previous posts on FCF interesting to actually try to estimate the intrinsic value of a company or two. There are a couple of very good lessons to be learned by doing so, at least one of which will crystallize in your mind the ideas presented by the book's authors on the value of a gorilla. Those graphs in the book will make so much sense.
When to calculate intrinsic value
This is purely opinion. I do not see any reason to enter into any valuation exercise until after identifying a company as having a certain set of characteristics. In this thread, that means gorilla or gorilla potential, or king. If you can't show that certain qualitative conditions are met, if you can't explain the company's competitive position and value chain, then you don't want to be investing in it, even if it is cheap. Now of course you should look at the financials, they can offer great insight into competitive position. But screening for FCF, or any of the other valuation methods, will give you a list full of companies that to be euphemistic, do not fit into gorilla gaming.
Find and analyze the company first. Then for those few that pass your criteria, estimate their intrinsic value.
How to handle free cash flow negative companies
This is also purely opinion. As a general rule, if a company has been consistently free cash flow negative, I would not look at it. Yes, this will cause you to miss out on some companies that end up giving great returns. But here is the key - you don't need to invest in every great opportunity. You don't need to catch every rising star to get great returns. Take a look at the two portfolios maintained by the thread. If you were to eliminate all the companies which are FCF negative in those portfolios (I don't know how many there are) there would still be more companies there than you would need to invest in.
Remember what others on this thread have said so well: "To grow wealth, concentrate. To preserve wealth, diversify." Think about this - if you are only going to hold a relatively small number of companies in your portfolio, which means that each one will be of a significant portion, do you really have room for a riskier company? The idea behind gorilla gaming is that a small number of companies with very special characteristics will give great returns with minimal risk. Alternatively, if a holding is of a very small percentage of your portfolio, what difference can it really make if it outperforms?
I don't think that finding more companies is nearly as important as winnowing the list of potential investments down.
OK, but I found this great company that has negative free cash flow, what do I do?
As I said above, as a general rule, I would not look at a company which has been consistently free cash flow negative. Consistently is the key word; you have to look at the company's history over the past several years. But, and this is key, the intrinsic value of a company is the present value of its future free cash flows. That means you have to make some assumptions and estimate its value. Which in turn means you need to come up with some idea of what future free cash flows the company might earn. When will it start to earn free cash flow? How much can it earn? If you can't get a handle on this in some way, IMO putting money in the company is not investing - it is speculating.
Since CREE was used as an example of a company which has been consistently free cash flow negative, here are some ideas on how I would approach it. First, recognize (better yet, check it out for yourself) that semiconductor makers are not the best generators of free cash flow. Second, recognize that small rapidly growing companies will often be poor generators of free cash flow, as they need to expand a disproportionate amount. However, don't take this lightly. An awful lot of them go under because of this. It sounds crazy that a company could go out of business, or go broke, or fail miserably because their business was booming, but it happens. Third, compare CREE to other semiconductor (or specialized electronics, if you prefer) companies of the same approximate size and maturity. Get a bunch of S&P reports, or look in Value Line Expanded, where they will all be together. If CREE's historical FCF is "normal" for that group, then you can think about whether that group is a good place to invest, you can think about how CREE could differentiate itself in this going forward. If CREE's historical FCF is worse, than you can quit looking, or you can dig in and find out why. Fourth, after you have done some digging, and thought about what it means, contact the company, and ask them about it. Note, you will have to be fairly informed to ask specific questions and get good answers; simply asking why FCF is low will get you nothing.
After all that, if you don't have a handle on the business, if you don't have enough info to at least crudely estimate intrinsic value, drop it. Put your efforts and money into something else. If you have enough info,and are still interested, estimate the intrinsic value and then make an informed investment decision.
I'll end this with a true story that may give you pause on assuming a company is doing what they should be doing during their expansion phase. A certain small cap tech company, in a business projected to grow on the order of 50% per year by the technology analysts, and considered the leader. But their free cash flow was poor, with high capital expenditures. It turns out that they decided that to successfully expand, they should relocate their plant to a location where the labor pool was better. So they opened a new plant. Then they decided, for some reason, that it wasn't paying off fast enough, so they closed it. A year later, they decided to try again - same location, but starting over. What do you think this was doing to their capital expenditures? (They were also noteworthy for spending an inordinate amount on SG&A, surprise surprise.) Yes, their stock price went racing up for while in the beginning, but their inability to make real money caught up with them. Business is stagnant, growing very slowly, because of the financial constraints they effectively created. What would you guess investors want to pay for their stock now?
Again, thanks to all.
- Pirah
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