A crucial part of our process when evaluating companies is understanding free cash flow production. Sometimes companies that can appear to be incredibly good value turn out to be value traps.
In this example we will take two companies to demonstrate the importance of fundamental research when evaluating companies.
Broadcom is a semiconductor and software company, and Goodyear is a tyre manufacturer similar to Bridgestone.
In January 2021, Goodyear was trading on only 3x P/E, Broadcom was trading on 26x P/E. Knowing nothing more about these companies you might think Goodyear is a better investment…
We think long term Free Cash Flow production is the best way to value a company. Therefore, our process on the Global Equities Team is to value all of our companies on the Free Cash Flow per share they produce in 3 to 5 years time, plus all of the accumulated dividends we receive.
Free cash flow (FCF) is the money a company has left over after paying its operating expenses and capital expenditures.
Companies that pay sustainable and growing dividends typically produce sustainable Free Cash Flow growth. This is because to pay a sustainable and growing dividend a business must have a healthy balance sheet and generate sustainable and growing Free Cash Flows.
Perhaps, unsurprisingly then, the starting point for all of our proprietary models are a company's reported Net Income and Free Cash Flow from their annual reports (10K). A focus on bottom-up stock research and proprietary Free Cash Flow forecasting is critical because it is a company's future free cash flow that rewards shareholders. Thus, we must make forward looking judgements about free cash flow generation and the price we pay for that.
We have turned the annual reports into simplified Income Statements and Free Cash Flow Calculation for both Goodyear and Broadcom. We have then adjusted these reported figures to determine what is sustainable Free Cash Flow for the companies.
| Goodyear Simplified Income Statement | Broadcom Simplified Income Statement | |||
|---|---|---|---|---|
| Sales | 17,478 | Sales | 27,450 | |
| Net Income | 764 | Net Income | 6,736 | |
| Goodyear Simplified Free Cash Flow Calculation | Broadcom Simplified Free Cash Flow Calculation | |||
| Net Income | 764 | Net Income | 6,736 | |
| Depreciation and Amortization Goodwill impairments | 1007 | Depreciation and Amortization Goodwill impairments | 6,041 | |
| Cash Tax Payments | -471 | Cash Tax Payments | -809 | |
| Cash Restructuring Charges | -197 | Cash Restructuring Charges | 0 | |
| Cash Pension Charges | -48 | Cash Pension Charges | 0 | |
| Cash Lease Charges | -278 | Cash Lease Charges | 0 | |
| Working Capital | -104 | Working Capital | -127 | |
| Other | 389 | Other | 1,923 | |
| Total Cash Flows from Operating Activities | 1,062 | Total Cash Flows from Operating Activities | 13,764 | |
| Capital Expenditures | -981 | Purchases of property, plant and equipment | -443 | |
| Free Cash Flow (Invesco Definition) | 81 | Free Cash Flow (Invesco Definition) | 13,321 | |
| M&A | -1856 | M&A | -8 | |
| Dividends | 0 | Dividends | -6,212 | |
| Share Repurchases | 9 | Share Repurchases | -1,299 | |
| Ratios | Ratios | |||
| Free Cash Flow (Invesco Definition) | 81 | Free Cash Flow (Invesco Definition) | 13,321 | |
| Net Income | 764 | Net Income | 6,736 | |
| Free Cash Flow Conversion (FCF/Net Income) | 10.6% | Free Cash Flow Conversion (FCF/Net Income) | 197.8% | |
| Free Cash Flow Margin (FCF/Sales) | 0.5% | Free Cash Flow Margin (FCF/Sales) | 48.5% | |
| Valuation as at 01/01/2021 | Valuation as at 01/01/2021 | |||
| Market Cap | 2,371 | Market Cap | 172,942 | |
| Enterprise Value | 7,885 | Enterprise Value | 210,751 | |
| P/E ratio | 3.1 | P/E ratio | 25.7 | |
| P/FCF | 29.3 | P/FCF | 13.0 | |
| FCF yield | 3.4% | FCF yield | 7.7% | |
| EV/FCF | 1.0% | EV/FCF | 6.3% | |
| Dividend yield | 0.0% | Dividend yield | 3.6% | |
| Total Shareholder yield | 0.4% | Total Shareholder yield | 4.3% |
Source: Invesco
In our view Broadcom was much cheaper than Goodyear. Broadcom was on 13x Price to Free Cash Flow, and Goodyear was on 29x Price to Free Cash Flow.
In layman's terms, for every $100 of Net Income, Goodyear only made $10 of Free Cash Flow (10% conversion ratio). This means that Goodyear is on a PE ratio of 3x, but a Free Cash flow ratio of 29x.
Meanwhile, Broadcom turned every $100 of Net Income into $115 of Free Cash Flow! This means that Broadcom was on a PE ratio of 26x but a Free Cash Flow ratio of 13x.
Free Cash Flow is so important because companies pay for R&D, Capex, Acquisitions, Dividends and Buybacks in cash, not profit. It is these factors that generate future sales and cash flow growth. Which in turn generate future long term share prices.
Source: Invesco
Goodyear continued to generate very little Free Cash Flow: despite generating a total net income of $277m in the 3 years to 2023, their free cash flow was -$477m! As a result, they did not pay any dividends, buyback any shares or make any acquisitions.
Over that same period, Broadcom continued to generate very large amounts of Free Cash Flow: they generated a total net income of $32bn, with free cash flow generation of $47bn! As a result, they were able to grow their Free Cash Flow by continuing investing in R&D and products, whilst paying out large dividends ($20.9bn), repurchasing shares ($11.5bn) and they made a $61bn acquisition that at the end of 2023 that will be reflected in the 2024 accounts.
Ultimately, it is a company's cash investments in SG&A, R&D, M&A and capex that drive its future sales and Free Cash Flows. We as shareholders also benefit from increasing dividends and repurchases. These investments and shareholders returns can only be made out of cash, not profit. Therefore, it is our firm belief that Free Cash Flow per share growth plus dividends accumulated is what drives long term share prices.
In the very short term, share prices are almost random: Goodyear (GT) actually outperformed Broadcom (AVGO) dramatically in 2021. However, in the long run, the market rewards sustainable Free Cash Flow growth: at the time of writing, Broadcom has outperformed Goodyear by around 196% since the start of 2021.
If you extend your time frame out even further, you can see just how much the market cares about Free Cash Flow and dividends. In the end, this is all that matters.
Since Broadcom's IPO in 2009, the shares have compounded at 38% which is roughly in line with its FCF per share growth since IPO (32% CAGR) plus its dividend yield (2%). Over that same period, Goodyear shares have compounded at -2%…this makes sense because they have generated no Free Cash Flow per share growth.
Source: Bloomberg, as at 16/02/24
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Data as at 20 February 2024, unless otherwise stated. This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. Views and opinions are based on current market conditions and are subject to change.
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