Contact Your Financial Adviser Money Making MC
10 November 2016
When analyzing stocks, Booth focuses not so much on
conventional measures such as price-earnings multiples, but on a company's
ability to generate free cash flow. Consequently, at the heart of his
analytical process lies the ability to grow free cash flow over time and the
management's allocation of capital.
According to him, the ability of management to allocate cash
flow properly determines whether the value of the business will rise or fall.
If a company can invest that cash flow, either internally or externally, and
generate a marginal return on invested capital that exceeds the marginal cost
of capital, then making that investment will increase the value of the
business. The Total Investment & Insurance Solutions
And what can management do with free cash flow? Booth cites
five options (which the firm graphically presents below):
• Pay a cash dividend
• Buy back stock
• Pay down debt
• Make an acquisition
• Invest internally, in research and development for
instance.
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| Free Cash Flow (The Total Investment & Insurance Solutions) |
The firms two CIO’s – William Priest and David Pearl, in an
interview with Barronsdelved on the same issue. Priest said that the first
question he asks a company is: “How do you allocate capital?” If they say,
“We’re a growth company; we reinvest every dollar internally,” that’s a very
bad answer.
A better answer would be, “We think our cost of capital is
4%, 6%, 7%, 9%… To that we add 800 basis points [8%], and arrive at a hurdle
rate for reinvestment. We will reinvest or acquire down to that number.
Anything in excess of that -- what we don’t need for working capital -- we
return to shareholders.”
Saying that does not necessarily mean a company is any good
at it, but it does point to the fact that they have a sensible methodology. The
Total Investment & Insurance Solutions
Pearl explained that if you only buy companies that generate
cash, they never go bankrupt -- even during a financial crisis. The Total
Investment & Insurance Solutions
There is sound logic behind why Epoch’s security selection
process is focused on free-cash-flow metrics as opposed to traditional
accounting-based metrics such as price-to-book value and price-to-earnings
ratios. Earnings growth and dividends drive shareholder returns, and they come
from a single source - cash flow. Hence the focus on companies that are growing
free cash flow and allocating it intelligently.
The investing philosophy favours reinvesting cash flows in
internal projects or acquisitions only when those actions generate returns
above the cost of capital. Otherwise, they are of the opinion that company
managements should return excess cash to shareholders through dividends, share
buybacks or debt repayments -- collectively known as "shareholder
yield." The Total Investment & Insurance Solutions
In conclusion…
At its most basic level, free cash flow, or FCF, can be
calculated as operating cash flow minus capital expenditures: FCF = Cash flow
from operations - capital expenditure
Investors must use this measure to identify companies with a
consistent ability to both generate free cash flow and to allocate it
intelligently. Observe free cash flow over a period of a few years rather than
a single year or quarter.
No one is saying that this is the only parameter to follow,
but by employing it, investors can at least eliminate most bad investments.The
Total Investment & Insurance Solutions
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