The search for sustainable free cash flow

Some investors screen for companies with lots of free cash flow. They then look to see if they can buy the shares for a reasonable price. Typically they will look for low multiples of Price to free cash flow (P/FCF) or a high Free cash flow yield (FCF/P).

There's nothing wrong with this at all. You just have to make sure that the free cash flow numbers you are looking at are a reliable indication of what the company can produce year in, year out. If they are not then you could fall into a trap of buying a company which you think is growing its free cash flow and becoming more valuable when it isn't.

Just as company management can manipulate profits they can manipulate cash flows as well - especially in the short run. They can do things such as cutting back on investing in new assets (capex) but one of the quickest ways to boost cash flow is to reduce the amount of working capital tied up in the business.

Working capital is the money that a company needs to operate on a day-to-day basis. Some companies need more of it than others. That's because they might need to hold lots of stock, pay for things in advance and sell goods to customers on credit. All this can be a drain on a company's cash resources.

Reducing working capital boosts a company's operating cash flow - the amount of cash coming in from trading activities. However, this boost might not be permanent and might confuse an investor into thinking that a company's sustainable cash flow is higher than it might be in reality.

The change in working capital is recorded in a company's cash flow statement - in the Net cash from operations section at the top. SharePad users can see this on the Cashflow tab in the Financials view. In the example below, you can see the working capital has increased by £53.5m in the latest accounts. You can also see how this has been achieved in the breakdown above it.

In this article, I am going to spend some time looking at this working capital issue because I believe it is too easily overlooked by investors. Bear in mind that annual cash flows can also be distorted by one-off cash flows like tax refunds, pension fund top ups, litigation and restructuring costs. I'll look at this in a future article.

Let's take a look at an example to understand this better.

Reality bites

Whilst the chief executive is celebrating his big bonus payment as a result of his efforts he quickly sobers up when his finance director brings him down to earth with some harsh realities.

The amount of stock has been reduced to its limit. The warehouses are struggling to supply customers and provide spare parts. There's no way that stock levels can go lower than 15% of sales without compromising customer service.

Customers are complaining that they can't pay them any faster without putting themselves in financial difficulties. They only way they will do so is if they can buy lawnmowers for 20% less than they are now.

Suppliers are getting grumpy and don't want to be kept waiting any longer for their money. They feel they've been squeezed enough.

The chief executive's heart sinks. He knows that he has maxed out on the gains from squeezing working capital. He also knows that if there is no cash boost next year from changes in working capital then operating and free cash flow will fall. This is exactly what happens.

Even with sales and profits growing, the ratio of working capital to sales stays the same and there is no cash flow improvement from it. Free cash flow falls back to almost the same level as it was before.

The lesson here is to be wary of companies that boost their cash flow from decreases in working capital. Whilst such moves are welcome they rarely lead to permanent improvements in free cash flow. You therefore need to be careful when valuing companies on the basis of free cash flow where this has occurred.

Should we use cash profits for valuing shares instead?

The problem with using free cash flow to value companies is that the yearly movements in working capital can give investors a misleading picture of a company's sustainable free cash flow and possibly lead them to make mistakes when valuing it.

The solution to this problem could be to base share valuations on an estimate of a company's cash profits instead. Cash profits are calculated by adjusting profits for an estimate of maintenance or stay-in-business capex - the cash required to maintain the company's. This measure ignores the cash effects of changes in working capital.

See my article on How to work out a company's cash profit for more details.

This is the way that Warren Buffett values companies. He calculates cash profits (or owner earnings as he calls them) using the following formula:

Post-tax profit + Depreciation and amortisation - Stay-in-business capex.

Here's how Halfords looks on this measure.

I've used 5 year average capex figures as an estimate of stay-in-business capex. As you can see, the cash profits are very similar to net income suggesting that Halford's reported profits are very close to its actual cash profits. This will not be the case for every company but it is here. As a result, Halford's price to cash profit ratio will be very similar to its price to earnings (PE) ratio.

To sum up

1. The valuation of shares should be based on a measure of sustainable profits or cash flows.
2. Free cash flow isn't always the best number for this.
3. Free cash flow can be distorted by one-off effects such as tax refunds, litigation and restructuring costs as well as pension fund top ups.
4. Cash flows from changes in working capital can lead to big changes in a company's operating and free cash flow.
5. Management can boost operating and free cash flow by reducing working capital in the short run. This is a one-off rather than permanent boost to cash flow and can give a misleading measure of sustainable cash flows.
6. Calculating cash profits is probably a better basis for valuing shares.
7. Free cash flow still remains a very useful way of analysing a company's performance.