Wednesday, December 26, 2012

Enterprise Value to Free Cash Flow

From this Barron's article:

Four Stocks Gushing Free Cash Flow

On Microsoft (MSFT):

"Its net cash balance, combined with yearly free cash flow, works out to enough money to buy the entire company over the next six or seven years."

Now, if that free cash flow (FCF) is about to drop off in a big way, then the valuation is actually a whole lot less cheap than it seems. Microsoft isn't the only tech company with both lots of cash on the balance sheet and free cash flow relative to its total market value.

Yet it is certainly as good an example as any right now.

The first thing I hear when the subject of Microsoft's stock comes up. "The stock has done nothing for a decade plus" or something similar. That's certainly correct, but it's worth taking a bit closer look for context.

December 24th, 2002*
Closing Price: $ 26.91
Shares Outstanding: 10.9 billion
Market Cap: $ 294 billion
FCF: $ 8.1 billion
Price/FCF: 36x
Dividend Yield: N/A

Accounting for the net cash and investments, the enterprise value (EV)** to FCF was more like 30x.
(~ 30 years to produce enough money to, along with the cash and investments on the balance sheet, buy the entire company.

Now, ten years later...

December 24th, 2012
Closing Price: $ 27.06
Shares Outstanding: 8.5 billion
Market Cap: $ 230 billion
FCF: $ 23.8 billion (incl. goodwill impairment)
Price/FCF: 9.7x
Dividend Yield: 3.4%

Latest 10-K
Latest 10-Q

Just about a tripling of FCF and a 22% drop in share count puts EV to FCF at roughly 7x.

In late 2002, investors were willing to pay ~ 30 dollars of EV for every dollar of FCF or a roughly 3.3% FCF yield.
(This FCF yield reflects the market value that's not backed by a dollar of cash and investments on the balance sheet. The yield would naturally be lower based purely on market value.)

That relatively small FCF yield was little wind at an investors back.

So, of course, growth was crucial.

These days, investors in Microsoft will only pay ~ 7 dollars of EV for every dollar of free cash flow.

A 14.3% FCF yield.

That 14.3% FCF yield, in contrast, is quite a wind at the investors back even without growth. All that's needed is that the cash is put to reasonably intelligent use or returned, where appropriate, to shareholders via buybacks or dividends (though that the cash will be allocated in a smart way can hardly be considered a given). Well, that and, once again, for free cash flow to not meaningfully drop off.

Those willing to pay that kind of multiple back in 2002 had to take the financial hit of a contracting multiple even though the company actually did just fine.
(Tripling free cash flow over a decade and shrinking the share count 22% isn't a bad decade of work. Imagine the position those investors would be in if the company had produced more modest business growth.)

Investors, at least for now, simply want to pay less than a quarter as much enterprise value for every dollar of earnings. The reasons can be debated but that's the current reality.

So the same company (though not necessarily the same prospects, of course) is being valued, right or wrong, very differently just one decade later.
(Maybe today's price appropriately reflects value. Maybe not. Obviously, more than a few investors were quite comfortable in paying the then prevailing higher multiple of FCF for shares of Microsoft a decade ago. Having produced very poor returns, that price a decade ago with the benefit of hindsight seems, if not necessarily "wrong", far from "correct". Who says today's price somehow reflects more enlightened views?)

What if a similar attitude or mood adjustment occurs (based upon changes to a company's real or perceived prospects) with respect to valuation, for some of today's high fliers? If so, those who pay today's exceptionally high FCF multiples might similarly have to take the financial hit.

The solution seems simple enough. Pay a low enough price so attractive returns can occur without getting an exceptional price when it comes time to sell. Pay a price that doesn't depend upon exceptional business performance.

In other words, buy at a price so if things don't go quite as hoped, the investor will still be compensated well for the risk.
(If there's little or no growth and no expansion in the multiple where does the return come from? Well, in this example, it's the 14.3% FCF yield put to good use...ideally mostly in the form of buybacks and dividends.)

Expecting a not so great price at the end of an investing horizon imposes discipline on what one is willing to pay now. Some might think it's not possible to achieve attractive returns this way. Well, it is if the investor buys at the right price in the first place.

"...Mr. Market suffers from some rather incurable emotional problems; you see, he is very temperamental. When Mr. Market is overcome by boundless optimism or bottomless pessimism, he will quote you a price that seems to you a little short of silly." - Benjamin Graham in The Intelligent Investor

This requires investing over longer time horizons -- and lots of patience -- but is more than doable. Of course, selling in a euphoric market with lofty prices is preferred, but an investor should not (and doesn't have to) pay a price that depends on it. Also, when the price paid is a low multiple and a substantial discount to value, the near-term price action becomes inconsequential and mostly just a head I win, tails I win situation. This seems underappreciated.***

If, at the end of the investing horizon, a good sale price does end up being a available to the owner, there will obviously be no complaints.

Investors have control over what they're willing to pay upfront for an asset. They don't have control over what prevailing market prices will be down the road. They also don't have much influence over future business performance (unless, maybe, a capable activist with enough shares). Well, that means those who pay a high multiple of earnings become heavily dependent on two things they don't generally have control over: business performance and market prices.

Future business performance is unpredictable. So is the ability and willingness of others to buy at an attractive valuation many years from now. Buying with a clear margin of safety is protection against those things that are not controlled by the investor.

Microsoft's current prospects (or perceived prospects) has led to a low EV to FCF multiple. That, combined with the high multiple paid a decade ago, means investors in the stock haven't done well this past decade. Fortunately, the growth in earnings and buybacks at least offset some of the potential damage. That won't always be the case for those who are willing to pay a high multiple for a particular stock.

I'm not suggesting it's never wise to pay a high multiple. Yet, when an investor pays something like a 30x multiple of FCF (and in many other real world examples, much more), there's obviously a lot of growth expectations built into that price. There's little margin of safety to protect against what might go wrong. Not much wind at an investors back (3.3% FCF yield isn't much if unexpectedly the growth happens to disappear or worse) without that growth. If those expectations don't pan out, it will be costly. So those that do pay high multiples (for what often are the most exciting business stories) had better be very good at judging the future prospects correctly a very high percentage of the time. One big loser can easily undermine the compounding effects of many winners. Some seem to underestimate the incremental risk they're taking on.

Figuring out prospectively whether huge expected growth will eventually become reality -- and paying up for it -- seems difficult at best to get right consistently.

A different approach is to assume that, at least most of the time especially in highly dynamic industries, the future is just too unpredictable and unknowable. Too many opportunities to make mistakes. So, instead, rarely if ever pay a premium price for a promising future. Pay a price where nothing exceptional has to happen to yield a more than satisfactory long-term result. Pay a price that assumes one's own ability to correctly predict future outcomes is unlikely to be reliably correct.

It's just often less difficult to find an undervalued security that will produce attractive risk-adjusted returns despite unexciting growth prospects (or maybe because of real -- even serious -- but in the long run fixable business difficulties). The key is to not buy what seems cheap but has it's core business franchise under some kind of meaningful threat.

Occasionally, with this approach, something good actually ends up happening (consider it a bonus) but exceptional foresight was not required. Many overestimate or are overconfident in their ability to have consistently good foresight. Instead, pay a price that doesn't require it and then end up, on a few occasions, being pleasantly surprised.

What doesn't work out in weeks or months may work quite well, on a risk-adjusted return basis, over many years. If bought cheap enough, a small misjudgment can be erased in short order if the sheer size of per share FCF is substantial compared to the price paid. Pay a high multiple of per share FCF and a similar misjudgment might require decades to overcome.

Think of it this way. A 7x multiple stock that drops 50% can, without growth, buy back all shares outstanding in 3.5 years at that reduced price. Practically speaking, that means it will not be long -- at least in the context of investing if not trading -- before the substantial amount of FCF relative to market value puts, sooner than later (short of it going private), meaningful pressure upward on the stock price. Of course, it's possible those in charge will figure out ways to burn some of the cash instead of using it to buyback shares at what would be a 28.6% FCF yield. Otherwise, that's what I meant above when I said it's head I win, tails I win situation. A stock selling for 30x earnings that drops 50% still needs another 15 years unless lots of growth materializes. If not, the upward pressure from buybacks might not be obvious for a very long time.

So not all 50% drops in price pose equal long run risks of permanent capital loss. In the case of a stock with lots of net cash and investments, it takes less than a 50% drop in the stock to result in a 50% drop in enterprise value. As an example, Microsoft's stock price -- because of its net cash and investments position -- would actually only have to drop roughly 35-40% for its enterprise value per share to be cut in half.
(The math is straightforward if not initially intuitive. The cash is a reverse lever.)

Warren Buffett's "first law of capital allocation", as articulated in the 2011 Berkshire Hathaway (BRKa) shareholder letter, seems relevant here:

"..,what is smart at one price is dumb at another." 

The inherent risk of an investment can't be viewed in a vacuum. The price paid relative to a conservative estimate of intrinsic value dictates the risk being taken.

This post certainly is not intended to be about the merits of Microsoft as an investment. In fact, though I have a stake, I'm not the biggest fan of the company's shares as a long-term investment. Too many capable well-financed competitors. Too much unpredictable technological change. As I've explained previously here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. They generally have been and likely will continue to be, at most, smaller positions. Tech businesses with seemingly attractive economics today too often prove that those economics aren't sustainable down the road.

The best businesses have durable economic characteristics. They have attractive core business economics (high return on capital) that can be expected to last a very long time. They sometimes benefit from technology and innovation but rarely do they compete in such a dynamic realm.

When an investor pays a premium for the promise of exceptional growth prospects that don't materialize, the end result is often permanent capital loss. The investor who never pays a premium price -- and, instead, always buys at a plain discount -- is less likely to be exposed to costly disappointments. The price paid should merely require decent business performance to get a good investment result.
(Of course, it'll be hardly a problem if a good unforeseen thing does end up happening. The important thing is to not be dependent on it as an investor.)

Intrinsic business value, in general, comes mostly from the excess cash that a business will produce for as long as it exists.
(Discounted at an appropriate rate.)

The problem for investors is that there's no way to know precisely the amount of cash flow over time. Also, when it comes time to sell, there's no way to know what the prevailing multiples might be. Now, an investor can decide to wait for a price that represents intrinsic value more closely, but it's better to assume that won't be possible. Knowing these things should make an investor want to build in a substantial margin of safety into their investing process.

Risk is reduced substantially when valuation is based upon modest or no growth assumptions. Some might be concerned about missing the "next big thing" and decide to pay whatever the necessary premium happens to be in the market.

Eventually, that might lead to some very costly mistakes.

Adam

Long position in Microsoft

Related post:

Technology Stocks

 * The stock was already down more than 50% from its peak. Closing price is split-adjusted. Split-adjusted shares outstanding is based upon what was reported in the latest 10-Q at that time. Net cash on the balance sheet (used for calculating enterprise value (EV)) and free cash flow (Net Income + Amortization & Depreciation - CapEx) is from what was at that time the latest 10-K. Also, the initial Microsoft dividend was yet to be announced.
** Market cap minus net cash and investments on the balance sheet.
*** Paying an extreme valuation leads to legit concerns over price action since so little intrinsic value underpins the shares. A huge proportion of price is promise that's yet to be backed substantively. Anything that threatens that promise -- or perceived promise -- becomes a huge problem that increases the risk of not just temporary but permanent capital loss.
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