Say you were buying a house as an investment. It costs £200,000 and you plan to rent it out at £1000 per month which comes to £12,000 per year. The return you get annually from this property (your yield) is £12,000/£200,000 = 6%. You are making a gross return of 6% on the £200,000 investment.
Of course, not all the 6% return goes to your pocket. Excluding any taxes you need to pay, some money will need to be put back into maintaining the property. The boiler may break down, the roof may get damaged or the house may need to be repainted. All of these costs will slightly eat at that 6% return. In some years, you will have to plough large amounts of money back into the property reducing your yield to say 3%. In other years, you don’t need to do anything, so all the cash goes straight to your pocket. Your actual earnings in a normal year is what matters and will probably be in the 4-5% range.
The second question you need to ask is how reliable are those cash flows? Will the tenant pay on time and in full? Do you have a long-term contract? Are there long stretches of time when the property will be empty? All these questions are trying to ask the same thing – how sustainable are those cash flows? My family have a property which we rent out and we have struggled to get the rent on time and in full. The reliability of the cash flows is very important. We have a one-year contract with the tenant, but this hasn’t helped us so far. Having a long-term contract puts the odds in your favour that you will receive your rent on time and in full, but it does not guarantee it.
The final question you need to ask is how much can your rental income grow? With a single property, you are limited to demand for houses in the neighbourhood as this gives you power to increase rents. However, much of the rental income can’t be used to grow the earning power of the property. You could increase the amount of rent you charge by adding an extension, a swimming pool, an extra room etc. Even if you were to do all of this, you inevitably hit a ceiling where additional investments in the property do not create additional value. Part of the rental income will be used to maintain the property and the rest ends up in your bank account. Your re-investment opportunities with a house are limited.
The story is similar but slightly different for stocks. For a non-cyclical and easy to predict business, using the method described above will work well in finding good value. The free cash flow (or owners earnings) is the leftover cash available to the owner of the business after he has re-invested a portion of that cash into maintaining the business.
Let’s go through the 3 requirements again, arranged in order of importance:
- What is the ‘normal’ free cash flow?
- How sustainable are the free cash flows?
- How much can they grow and where does the growth end up?
For these three points, I am going to value three companies that have stable and predictable cash flows as examples – Apple, Kone and Greggs. These companies are unique businesses that have contracts with their customers – literal and metaphorical contracts. Looking at historical margins can therefore be used as a guide to the future. I’ll also use a cyclical company to show how unpredictable they can be and the importance of using normalised free cash flows. The cyclical I’ll be looking at is BP.
1. The normal free cash flow
The normal free cash flow is amount of cash that shareholders receive in a normal year. For some companies, the number will fluctuate wildly so using recent 1 year, trailing twelve months (ttm) or even 3-year average free cash flow figures can be misleading, especially if the company is a cyclical and its profits depend on the price of an externality that can’t be predicted. Oil & gas companies and miners will fall into this group.
Using normal figures also means that the CapEx figure is normal. In some years, the company may spend a large amount in capital expenditures which will artificially reduce the free cash flow figure for that year. You want to adjust for this to show what you will get in a normal year
Using a 3-year average is also not useful for a growing company. A better way to think about normal figures is to look at the median free cash flow margin over a long term representative time.
Normalised free cash flow = Median FCF margin * Current Revenue
The representative time should ideally be more than 7 years and it should cover a full business cycle. Longer times are not necessarily better. The representative time should be long enough so that it covers different economic conditions. It should also be representative of how the company currently operates and generates cash. For a company like Apple, using the free cash flow margins over 10 years is ideal – it covers a recession and it coincides with the launch of the iPhone which was first released in 2007 and is currently Apple’s main source of revenues and cash flow. Using longer periods for Apple will artificially reduce its free cash flow margin because Apple in 2005 is a very different company to Apple today.
For Greggs, its ok to use a much longer representative time – the company has not changed that much over the last 20 years. Kone is slightly more complicated.
Kone manufactures and installs elevators and escalators. Using 15 years as the representative time works reasonably well. Kone has a high retention rate for its maintenance contracts. After installing an elevator or escalator, about 95% of its customers sign up for the maintenance contracts. This makes its median free cash flow figure more reliable because high retention rates increase the predictability of the business. However, Kone in the next 10 years may be different to what Kone looked like 10 years ago. This is because of emerging market growth. In China for example, foreign elevator manufacturers have struggled to get the lucrative maintenance contracts after installing an elevator. China is obviously an important market for Kone, with its large population and rapid pace of urbanisation, revenue from China and other emerging markets has increased as a percentage of total revenue. However, its inability to capture those stable maintenance contracts means its free cash flow margin will probably decline.
There is no hard-coded formula that can tell you the normal free cash flow of a company. You need to use historic numbers that cover a business cycle. Also, you need to have some certainty that the future will mirror the past. This means you need to know how sustainable those cash flows are.
2. How sustainable are the free cash flows?
After determining the normal free cash flows, the next thing to understand is how sustainable they are. The coefficient of variation of FCF margins is a good quantitative indication of how reliable those free cash flows are.
A small coefficient of variation means historic free cash flow margins have been steady and vice versa. For an oil company, it comes as no surprise to see such a large coefficient of variation. This happens for two reasons. Firstly, BP is very capital intensive and has long lived assets which will occasionally be replaced/upgraded to maintain or improve its production capacity. This capital spend will be sporadic – in some years very large and in others small. Secondly, the free cash flow margins depend on an externality (oil prices) that can’t be accurately forecast. These two points explain why BP has such a large coefficient of variation in its free cash flows. It is impossible to predict how BP will perform in any given period.
To understand if the free cash flows are sustainable, you need to understand if the future will mimic the past. You can determine this both quantitatively and qualitatively. Quantitatively, the coefficient of variation gives you some indication about the how reliable past cash flows have been. The lower the variation, the more reliable the cash flows. However, the future may be vastly different from the past. A chicken that has been fed by its owner all its life has no reason to think that same person will kill it for food one day. For the future of the business to be similar to its past, the company needs to have a contract with its customers. This can be a literal or metaphorical contract as explained here.
Apple and Greggs have strong metaphorical contracts. The retention rate of an iPhone is about 90%. Apple customers tend to be very sticky. For Greggs, it’s about price and habits. Greggs sells cheap snacks that people buy habitually. These two companies don’t have any literal long-term contracts with their customers. Sometimes metaphorical contracts are harder to break than literal ones because habits are hard to change.
3. What is the free cash flow yield and can it grow?
The final question you need to ask is how much are you willing to pay for the sustainable stream of cash? You can only calculate this if you have calculated the normal free cash flow and have some certainty over its sustainability. The free cash flow yield is calculated as:
Normal free cash flow/enterprise value
The enterprise value (EV) is a better estimate of what you are paying to acquire the business. The market cap does not include any debt or cash the business may hold. If you were to buy the entire company, you would be liable for its debts and get to keep its cash. The current free cash flow yields for the four companies discussed is shown below.
Apple has the highest free cash flow yields while BP has the lowest. Throw in the predictability of the former and the cyclicality of the latter and Apple becomes even more attractive than BP. With the exception of Apple, the yields are not great, but I would rather own Apple, Kone and Greggs at current prices than BP.
The final point about the free cash flows is how much can they grow? The yield + growth is a good estimate of your total return. For Apple, say it can grow at 3% a year from a combination of inflation, growth in its service business, iPhone price hikes, population growth etc. Your total return will be 5.7% + 3% = about 9% per year. At the current market level, this is a very good return.
The return you can expect from a predictable company is the sum of its free cash flow yield plus growth. Ideally the yield should be larger than the growth rate because the future is uncertain, and you should not count on very high growth rates to continue. However, the most important question you need to answer is whether the cash flows are normal and sustainable. Once you find a company with a high free cash flow yield, all your focus should be on determining how suitable those cash flows are. A company with literal or metaphorical contracts with its customers will naturally have the odds on its side.