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Strategies & Market Trends : Free Cash Flow as Value Criterion -- Ignore unavailable to you. Want to Upgrade?

To: Honest Abe who wrote (85)	11/2/1997 1:28:00 AM
From: Andrew	Respond to of 253

I'll take a crack at that one Abe.... There are some industries that don't tend to produce free cash flow because they are so capitally intensive - I'm thinking steel mills - heavy industry stuff. In that case it's impossible of course. These things are often valued on an asset basis I think. For my purposes, I kind of regard these cash consumers as having no investment value at all to me! But I don't pay much attention to those kinds of companies, so others might have more insight. I would hesitate to apply this stuff to cyclical companies such as automobile manufacturers and resource/commodity companies. Cash flows are so unpredictable there. Beyond specific types of companies, I have some opinions in a general sense. First, I don't have a good feeling about picking your stocks just because the FCF says they're cheap. As Warren Buffett puts it, I'd rather pay a fair price for a great company than a great price for a fair company. So my feeling is, pick your stocks based on a qualitative analysis of their prospects, management and financial characteristics. Then look at valuation. I think some people here like to screen for what's looking cheap now, and pick from that list. I kind of prefer to build up a "wish list" of outstanding companies I understand whose long term performance I feel good about. I keep an eye on them, and try to catch them when the market drives down their prices on short term thinking. This happens A LOT in the tech sector. Another generalization that I think is important regards why FCF valuation is meaningful at all. As everybody knows, most people in the market consider "valuation" and "P/E ratio" to be total synonyms. The media couldn't care less about discounted free cash flows. A P/E of 40 is "outrageously high", and 10 is a "good value". Maybe some "expert" will toss in wise-sounding comments about price-to-sales or asset or dividend-based valuations. I have no illusions that it's just a matter of time before everybody else sees things my way. I don't do FCF valuations because I expect the stock price to correct to what I see as "fair value". My central assumption is that companies with more money than they need to run their business have a clear advantage. Free cash flow is the fuel for future growth in the value of your shares. With it, smart management can make extra big investments in new products, create new markets. Or they can aquire external businesses which fill in holes in their product portfolio. Or they can give it to the shareholders directly through dividends, or indirectly through stock buybacks. These things all increase shareholder value if done properly, but I don't expect the market to "see this" overnight. What the market will see in the years ahead is higher earnings per share, which it will reward it's way. I imagine this scenario: Company X has lots of free cash flow, which it spends wisely. Unfortunately, the investor picks up some shares right before a long painful bear market. The investor was correct in choosing the company, which continues to grow impressively. But for several years, the market doesn't assign as generous P/E ratios as it used to. But the rational investor holds on, because he/she can clearly see the value of his/her investment growing with the company. Eventually, the market cheers up, and starts assigning "high" P/E ratios again in the next bull market. But Company X has tripled it's earnings per share in the meantime through free-cash-flow fueled growth. So the investor gets rich slow. So my feeling is, don't make short term bets based on free cash flow valuation. If you want to use your savings to buy a house next year, put 'em in a money market fund. Because free cash flow drives long term growth, not short term stock prices. Andrew