In the previous 4 posts, we analyzed the income statement, cash flow statement, and balance sheet looking for key measures of a good company, and we also looked at those same measures for a bad company. The purpose of this analysis was to help us decide which companies to add to our ultra-exclusive list of star companies which I call our Star List. This is essentially our shopping list of great companies with durable and sustainable high returns on capital over the long run. These businesses are rare – there are probably only a few hundred out of a universe of over 30,000 stocks globally. Usually, these stocks have some type of unassailable competitive advantage that confers upon them a monopoly-like moat around their castle.
Developing your list will be quite a bit of work and somewhat tailored to you. For example, someone who works in tech and has a large proportion of their net worth tied to stock and options grants in their tech employer may wish to underweight tech stocks in developing their list. Only you can know your circumstances, so your list will be personalized to an extent. However, once you have developed your list, the next stage will be the decision of when to buy a stock on your Star List.
We developed the Star List of companies without regard to valuation, but when we decide to buy, we want to make sure that we are purchasing great companies at good to great prices. Valuation and return on capital both matter to your returns, after all. In this post, we will focus on the valuation piece, to decide which of our companies on our list to purchase.
I use several measures of valuation, chief among them is price to free cash flow (P/FCF). We can calculate free cash flow in this manner:
FCF = OCF – Capex
where OCF is operating cash flow and Capex is capital expenditures, capitalized software development costs, intellectual property development costs, and anything that is needed that is capex-like to keep the business running. Free cash flow is better to use than earnings, in my opinion, because there is less ability to manipulate cash flows without committing outright fraud that risks jail time for the perpetrators. The disadvantage of cash flows is that they tend to be less smooth than earnings, but I would rather smooth cash flows myself by averaging than use a measure that is averaged for me but open to much more manipulation.
Therefore, I do use an averaged free cash flow in calculating the P/FCF for each company on my list. For cyclical companies that are not growing much, I like to use a 7 year average of free cash flow, because the average business cycle is about 7-10 years for a company. This is short enough that it can avoid masking growth too much, but long enough to average over a business cycle and remove the cyclicality. For companies that grow and/or are non-cyclical, I like to use a 3 year average of cash flows. This masks the growth of a fast-growing company even less, but still averages out one time big dips and jumps in cash flows quite well.
Once I have an average price to free cash flow, I can compare most of the companies on my list directly and pick some of the most favorable to purchase on a P/FCF measure. Buying low P/FCF stocks has been shown to be predictive of greater excess returns vs. more easily manipulated strategies like buying low price to earnings (P/E) stocks. This works for most non-financial stocks. For financial stocks, calculating P/FCF often does not make as much sense. There are more complicated ways to calculate a substitute for free cash flow, so that banks can be compared directly to other businesses. But often, it just makes sense to calculate price to book (P/B) for banks, for example, and compare these to each other separate from non-financial businesses.
Another measure I utilize is price to free cash flow to growth (P/FCF/g). Many companies that are outstanding and are also growing fast will have a premium P/FCF. If you ignore that they are growing at rapid rates, you would never choose to buy them, but they grow into their valuation so fast that it can be worth it to consider them. The trick is not overpaying for growth. The measure of cash flow that I use is backward looking since it averages past years, and I prefer it that way. I would rather a company demonstrate what it has done than offer rosy optimism about what it will do in the future.
Similarly the growth I use in the P/FCF/g calculation is the average growth over the last 7 years (again, roughly 1 business cycle). As with cash flows, I would rather use the growth that a company has demonstrated in the past rather than the rosy view of what it promises for the future. In this way, the P/FCF/g provides a forward looking view that advantages fast growing companies, but it is still heavily grounded in the reality of what has actually occurred for past growth and cash flows.
Some other measures that I use, but which are less important are dividend yield and dividend growth, as well as buyback yield. Higher dividend yields than the historical average for a company can be indicative of the possibility that the company is currently on sale. Companies that are growing their dividend at a high rate can also enrich investors, a fact that might escape you if the current dividend appears low. Companies that buy back their stock at a high rate and increase the ownership of shareholders can be indicative of good, responsible management. I usually use dividend, dividend growth and buyback yield to get a different look at the companies I am tracking and see if anything comes to my attention. I don’t usually put as much emphasis on these measures as I do on P/FCF and P/FCF/g, which are the primary ways I assess good value.
I believe doing intelligent value investing in high quality companies with a durable and sustainable return on capital will lead to excellent returns over the long term. Much moreso than the typical naive application of value in the style of Fama and French where every company that scores well on value is purchased without looking at the underlying mechanics and financials of the business. That naive method of buying everything that scores well on value will pick up many value traps, and will also necessitate buying and selling every so often to get the next batch of value stocks. Turnover, as we have seen, is detrimental to returns. Similarly, buying “cigar butts” (companies that are bad but have one last little bit of value that can be extracted before they die) requires higher risk and turnover. These companies have been poured over by many smart people and you are unlikely to find something they don’t unless you are truly a unique thinker.
Rather than chase after these other methods of value investing, I believe it is best to buy these fantastic companies when they go on sale at great prices and then try to hold on forever.
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