Companies with high free cash flow margins and high free cash flow yields massively outperform the market over time

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In our previous dispatch, we learned that return on investment (ROIC) is the most important financial metric because:

  1. An increase in ROIC always increases the company’s intrinsic value, but revenue growth does not always increase intrinsic value. Revenue growth only increases intrinsic value when the ROIC is above the weighted average cost of capital (WACC).
  2. Companies with a high return on investment outperform the stock market by a country mile.
  3. And companies with rising ROI (and high incremental returns on invested capital) outperform the market even more!

Return on invested capital is calculated as net operating income after tax (NOPAT) divided by average invested capital, so it has a robust profitability metric in the numerator and a balance sheet measure in the denominator. In this way, it is the linchpin that connects the profitability (income statement), balance sheet and free cash flow (FCF) of a company.

And strong and growing free cash flow (especially FCF per share) is ultimately what we seek as investors. As we stated (and repeated) in the linked article and now rephrase, companies with higher ROI generate more FCF per dollar of earnings, and free cash flow growth is what stimulates the growth of intrinsic value! In fact, the definition of intrinsic value (also called fair value or fundamental value) is the present value of future free cash flows. Fair value can also be thought of as the price you can pay for a stock and earn approximately your required rate of return (or cut-off rate in your discounted cash flow model).

The great Michel Mauboussin says (100% right, I might add) that all the quantitative and qualitative work (due diligence) that we do as analysts serves a single purpose and a single job: to help us estimate (with a high enough degree of certainty) the free cash flow a business will generate by the end of that business’ life, and then compare our free cash flow growth estimates to the free cash flow expectations embedded in the share price. Then, when we think expectations of future free cash flow growth are too low, we buy the stock. And when we think the future growth expectations of free cash flow embedded in the stock are too high (and even extreme and insane as we saw in 2020-2021), we can choose to reduce or sell the stock.

That’s it, fools. All the weeks and months (and sometimes years) of research and analysis we do as investors is only meant to make educated guesses about how much free cash flow the company will generate. and how fast that free cash flow will grow. the forecast period in our discounted cash flow models.

So if it all comes down to free cash flow, it’s no surprise that companies that generate high free cash flow margins (FCF divided by revenue) and companies that provide free cash flow yields high free cash (FCF divided by enterprise value) also outperform the market by light years.

Chart showing how stocks in the top quintile FCF/EV outperform other stocks.

Free cash flow margin measures a company’s true economic profitability and cash generating power and is simply the number of cents of FCF a company generates for every dollar in sales. And the free cash flow yield is the inverse of the multiple of the company’s value relative to the FCF. Thinking in terms of yield allows investors to compare a stock’s FCF yield to the risk-free rate (the yield on 10-year US Treasury bonds), the yields of other stocks and bonds, and the yields of real estate investments. (the capitalization rate of a property is calculated as the annual net cash flow divided by the purchase price of the property). All other things being equal, whether it is stocks, bonds or real estate, higher yields indicate lower purchase prices.

Here’s how I like to think of free cash flow yield: a company’s dividend yield is how much money the company actually pays out as a dividend, but free cash flow yield is the amount of money the company could potentially pay out as a dividend if it elected to pay out all excess free cash flow as a dividend. As Bill Miller told me, “Empirically, free cash flow yield is the most useful metric. If a company earns more than its cost of capital, free cash flow yield plus growth is a good proxy indicator of expected annual return. Many of the world’s top investors use this FCF total return formula (FCF return + expected FCF growth over the next 5 years) when picking stocks.

Simply put, the FCF yield is the amount of money (as a percentage of the value of the business) that a sole proprietor could take out of the business each year to pay himself. This is the excess unencumbered free cash remaining after investing to maintain and grow the business, and is calculated as NOPAT less new invested capital, where invested capital is any form of investment, including including working capital, capital expenditures (property, plant and equipment), or acquisitions. Research and development (R&D) and sales and marketing (S&M) are also subtracted (recognized) from the income statement to obtain the NOPAT. So all growth investments are accounted for and free cash flow is what is left to pay all debt holders after investing in paying all bills and growing the business. Hence the term “free”. To learn more about free cash flow, this article by Michael Mauboussin is a must read.

This free cash flow is what matters most to us, as it can be used to reward shareholders by either (1) paying down debt (which reduces creditors’ claim on the company and strengthens the company’s financial position company), (2) paying a dividend, or (3) buying back shares at attractive prices. Then, any remaining free cash that is not used to repay debt, pay a dividend, or repurchase shares can appear on the balance sheet and be used at a later date (i.e. large cash and cash net create option value).

So, now that you know that companies with high and/or rising ROI and strong and growing FCF selling at attractive prices are outperforming the market, why don’t you focus your largest positions on companies that have a high and/or rising ROI with a high and/or growing ROI? or rising FCF margins selling at high FCF yields?

I’ve said it at least 100 times and I’ll say it again: strong free cash flow generation, a long free cash flow growth trail and the price we pay for it is really all that matters in the long run. term. investment success. If you want to live by the free cash flow method, read Investment Expectations by Michael Mauboussin and Al Rappaport. This is the best investing book I have ever read, and it could change your life. This is the way to invest nirvana, fools.

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