Capitalist Nexus

How often have you heard a fund manager or analyst praise a company’s ability to generate free cash flow? Typically a company review for the TV media goes like this:

“Company XYZ has a great business, and they expect to increase their free cash flow over the coming years by ABC%. We love that, and actively look for opportunities such as these to invest our clients money”.

The reporter on the screen cues up a serious look and says, “Good point, very interesting”.

Another mind numbing information exchange, and TV viewers really have no idea regarding what just took place, but continue thinking that somehow more Free Cash Flow makes a company valuable.

Free cash flow by itself means about as much to the attractiveness of a stock as the amount of toilet paper a company uses during a year. Basically nothing. After all, free cash flow is simply how much cash a company has left over after paying off its interest expense and capital expenditures in a given period. Whether that is good or bad depends whether the company can profitably grow, and what the market has priced into the company’s stock. For example, as The Wynn Casino was being built the company incurred massive negative free cash flow. Was it bad for the company to build its casinos in Las Vegas and Macau? Of course not, they have been wonderful investments. Typically very mature companies do not need all the cash they generate to reinvest in their business and as a result have the ability to create annual cash flows in excess of their needs. Whether that is good or not depends on what the market has priced into their valuation. If the market expects them to continue to expand and grow their business, then generating lots of additional free cash flow may be a very negative signal as management is saying the company does not have profitable growth opportunities. Another example, if the US opens up drilling off its coast, and Exxon Mobil decides to make a significant investment to find and extract that oil, at the detriment of its free cash flow – is that bad? Not if the investment earns a return in excess of its cost of capital. However, the typical free cash flow acolyte will likely be very confused as to how to evaluate whether or not that is a good decision by the company’s management team.

For most advocates of free cash flow, they likely equate free cash flow with being a value stock. Thus they tend to believe that more free cash flow means more value. More or less such logic ranks a few chromosomes better than those of a primate but hardly someone that should be managing money.

A much more interesting and accurate way in which to describe a business is in terms of:

1. Is management creating value, by earning returns on its employed capital above what investors require
2. Are management’s actions consistent with creating wealth, by getting rid of business units that earn less than their cost of capital or growing those earning more
3. What are the performance expectations built into the stock’s price and can the company comfortably achieve them

Those are the minimum questions that every fundamental based investor should be able to answer about any company they purchase. Further, journalist should be prepared to discuss each of those questions whenever they discuss a company for the benefit of their audience.

Ultimately free cash flow is just a summary of whether a management team is growing or shrinking its business. As many recent finance studies have shown, growth stocks have tended to under perform value stocks which have lead to free cash flow positive companies tending to outperform the overall market and make analysts that preach free cash flow look a bit intelligent. However, naively relying on such a historic relationship is a pathetic excuse for a process. Over time the market will adjust how it values future growth opportunities and as a result will eliminate its historic bias towards value stocks.