In the financial world of endless investment metrics and financial jargon, one term often stands out as a beacon for seasoned investors: free cash flow. Championed by investment mavens like Bill Ackman, this metric serves as a litmus test for business excellence and financial resilience. But why does free cash flow garner so much attention, and why is it hailed as the touchstone in value investing? Keep reading to learn the significance of free cash flow, drawing from the wisdom of investing legends and crystallizing lessons that could help your long-term investment strategy.
Bill Ackman on the Importance of Free Cash Flow
Here is the transcript of an interview where Bill Ackman talks about the importance of free cash flow in valuing an investment.
The interviewer said, “Go through that strategy and go through how it works. And when you come, you know, maybe you’ll override that portfolio manager. But what’s the checklist you kind of go through?”
Bill Ackman explained, “So, we look for very high-quality businesses what we describe as simple, predictable, free cash flow generative, dominant businesses. A business that Warren Buffett would describe as having a moat around it. Right? If you believe that the value of anything financial is the present value of the cash you can take out of it over its life, well, you need to know how much cash it’s going to generate over its life. So, business quality, to us, is the single most important criterion for determining what’s interesting. Because if we can’t predict the cash flows, we don’t know its worth. If we don’t know its worth, we can’t invest. And we figure out what it’s worth, figure out how good the business is, how predictable these cash flows will be, whether it’s from a railroad or a spirits company or a real estate company, a shopping mall business. And then we say, ‘Okay, well, where’s it trading?’ And if there’s a wide gap between price and value, if you can buy for 50 cents what’s worth a dollar twenty, well then, we’re going to take a hard look and try to understand why it trades at a deep discount. And once we understand the reasons, we decide: Are these things that we can solve? In light of the situation and circumstances, can we be influential in changing these levers that can cause this valuation discrepancy to narrow? And is this a business that, while we’re causing the valuation discrepancy to narrow, we can also perhaps contribute to the valuation growing? If those things are true, we’ve found something that looks quite interesting for us.”
The interviewer interjected, “And usually, this investment philosophy — does it take a week, a month, three months to do the research, a year? I mean, you have ten names. How long?”
Bill Ackman continues, “It depends. One of the best investments we’ve ever made took us four hours to do the work. It was during the financial crisis. It was that Wachovia Corporation. I was on my BlackBerry, eating breakfast at The Brooklyn Diner in front of my building, and a story went across — it was a Wall Street Journal headline, no, excuse me, a Reuters headline — saying that Citigroup was to acquire the Wachovia banking subsidiaries for two dollars in Citigroup stock. The stock was halted. This was an interesting transaction because they were buying the subsidiaries with Citigroup stock. I thought, ‘That’s interesting. What happens to the holding company?’ So, I went back to the office and cracked open the 10K. Another member of the team, Mick McGuire, he and I worked on it. What was interesting is, in the thousand-page 10K of Wachovia Corporation, I think 900 pages were about the banking subsidiary. There were fewer than 100 pages about the holding company. By buying the banking subsidiary, Citigroup was leaving a holding company which had cash, assets like Wachovia Securities, A.G. Edwards — they had paid six to seven billion for it just four to six months before — and Evergreen asset management. And they were taking a 27 billion dollar loss on the sale of the subsidiary. It also had a liability called non-cumulative perpetual preferred stock, which is the best kind of liability to have. It’s a form of equity where you never have to pay a dividend, and when you don’t pay, the dividends don’t accumulate. Worst case, they get a couple directors on the board, and you just say hi to them at each meeting. So, this was very interesting. I said, ‘This could be our Berkshire Hathaway.’ By the end of the day, we figured that the holding company was worth at least 11 to 14 in cash. A tax refund that you could carry back the 27 billion dollar loss, recover cash taxes that had been paid, this cash vehicle. Wachovia Securities, which was a good wealth management business, A.G. Edwards, and other assets, these are businesses we knew well. And the stock opened after it was halted, at a dollar eighty-four. So, we said, ‘It’s worth 11 to 14, it’s at a dollar eighty-four,’ and we bought 42% of the volume for the next four days. And then Wells Fargo came in and put in a topping bid of seven dollars in Wells Fargo stock, which wasn’t actually a topping bid, but the Wells Fargo deal did not require government assistance.”[1]
Why do we care about free cash flow?
Bill Ackman and Warren Buffett, renowned value investors, have often emphasized the importance of free cash flow (FCF) when evaluating businesses for potential investment. Here’s why free cash flow is deemed so crucial in making value investing decisions, drawing upon the teachings of these two investment giants:
- Fundamental Definition of Value: At its core, the value of any financial asset, be it a bond or a stock, is the present value of the cash flows you can expect to receive from it over its life. For stocks, the relevant cash flows are the dividends or, more broadly, the free cash flows the company can generate and distribute to its shareholders.
- Indication of Business Quality: Free cash flow directly reflects a company’s ability to generate more cash than it needs to reinvest in its business. A company that consistently produces strong free cash flows is likely a high-quality business with a competitive advantage or “moat,” as Buffett would describe it. This moat allows the company to earn returns on capital that exceed its cost of capital.
- Flexibility and Optionality: Companies with robust free cash flows have more flexibility. They can reinvest in their business, make acquisitions, pay down debt, buy back stock, or pay dividends. This financial flexibility is a significant advantage in both good times and bad.
- Protection against Over-optimism: Earnings often highlighted in financial reports can be manipulated with accounting tricks. Free cash flow, a more direct measure of the cash that flows in and out of business, is harder to manipulate and often provides a clearer picture of a company’s financial health.
- Indicator of Management Quality: How management deploys free cash flow can provide insights into its capital allocation skills. Buffett has always admired managers who allocate capital in a manner that maximizes shareholder value.
- Discount to Intrinsic Value: Value investors like Ackman and Buffett look for discrepancies between price and value. An investor can ascertain a company’s intrinsic value by estimating the present value of future free cash flows. It might be a good investment opportunity if the stock trades below this intrinsic value.
- Sustainability of Business Model: A company that consistently generates positive free cash flow will likely have a sustainable business model. In contrast, firms that fail to produce free cash flow may struggle to maintain their operations in the long run without external financing.
- The Basis for Dividends and Buybacks: Only with positive free cash flow can a company sustainably return money to shareholders through dividends or share buybacks. A company that pays dividends without the support of free cash flow may be overextending itself, which could be a red flag.
- Cushion Against Economic Downturns: In challenging economic times, companies with strong free cash flow have a buffer to weather the storm, whereas those without might face financial distress.
While other metrics and qualitative factors are undoubtedly important, free cash flow is a particularly crucial measure in value investing due to its direct link to business quality, financial health, and intrinsic value. Ackman and Buffett have used it as a foundational component in their investment philosophies, reiterating its importance in value investing.
Key Takeaways
- Core Essence of Asset Value: The true worth of any financial instrument pivots around the present value of prospective cash inflows from it.
- Benchmark of Business Excellence: Steady free cash flows often signal a dominant business fortified with a competitive edge.
- Financial Versatility: Firms with ample free cash flow enjoy diverse options, from debt reduction to strategic reinvestments.
- Guard Against Financial Embellishments: Unlike easily-manipulated earnings, free cash flow offers a more transparent view of fiscal well-being.
- The Gauge of Leadership Prowess: Observing how leaders utilize free cash flow can reveal their acumen in capital management.
- Indicator of Undervaluation: Estimating future free cash flows can spotlight stocks trading beneath their value.
- Sustainability Marker: Positive free cash flows hint at a resilient and enduring business model.
- Underpinning for Shareholder Returns: Dividends and stock buybacks rely on the foundational support of free cash flow.
- Economic Downturn Buffer: Businesses flush with free cash flow are better equipped to navigate financial turbulence.
Conclusion
Free cash flow emerges as a paramount metric for valuing a company, acting as both a beacon and a safeguard in the complex investing world. Drawing inspiration from Bill Ackman’s insights, it’s evident that this measure doesn’t merely represent numbers but encapsulates a business’s vitality, resilience, and essence. A firm’s ability to consistently generate and astutely allocate free cash flow is a testament to its financial strength. It’s an indispensable tool for discerning investors aiming to uncover actual value in the marketplace.
