A company is worth the present value of its future free cash flow. For companies like Amazon.com, investors project future cash flow to be much greater than it is today -- presenting a huge problem for shareholders if it never materializes. However, companies like Philip Morris International (NYSE:PM), Coca-Cola (NYSE:KO), and PepsiCo (NYSE:PEP) generate large sums of free cash flow today and enhance value per share through predictable capital allocation. As a result, shareholders of these companies can be reasonably certain that their investments will do well over time.
Cash conversion is key
For mature companies, cash flow maximization is key to growing shareholder value. The greater percentage of each dollar of revenue that the companies can turn into free cash flow, the more they can reinvest in the business and distribute to shareholders.
Philip Morris, Coca-Cola, and PepsiCo are good at converting sales into free cash flow. Since 2005, each company has turned more than 10% of its revenue into after-tax free cash flow. More importantly, each company generates a predictable free cash flow margin in most years, making it easier for investors to rely on present cash flow to predict future cash flows. Amazon, on the other hand, maintains a single-digit free cash flow margin.
The only questions investors need to ask themselves when evaluating these companies are: (1) How quickly will the companies grow revenue in the years ahead, and (2) will the companies continue to turn a similar percentage of revenue into free cash flow? Question one is easier to answer for these companies because they are growing slowly, so predictions are not likely to be off by too much. Question two is simply a matter of determining the companies' respective competitive positions; if each company retains its wide moat, then investors who buy at a low multiple of today's free cash flow will be rewarded -- assuming capital allocation increases shareholder value.
Management has two basic options when it comes to capital allocation: reinvest cash in the business or return cash to shareholders. Philip Morris, Coca-Cola, and PepsiCo do a combination of both.
According to corporate finance 101, management should only invest cash in projects that are expected to exceed the company's cost of capital. Projects that offer a high return on investment should get funded, while those that offer a low return on investment should not get funded and the cash should be returned to shareholders.
Philip Morris, Coca-Cola, and PepsiCo are so large that there are not enough high-return projects available to reinvest all of their cash flow. However, the projects in which they do invest have historically generated high returns. If you average each company's return on assets and return on invested capital since 2005, you find that Philip Morris generates a 28% return on investment and Coca-Cola and PepsiCo generate a 17% return on investment.
Management thinks about investing in projects like investors think about investing in stocks; a 17% compound annual return on investment is really good, so shareholders are rewarded when management invests in these projects.
Share repurchases and dividends
Unfortunately, Philip Morris, Coca-Cola, and PepsiCo are unable to reinvest all of their cash flow at such high rates. Instead the companies invest as much as they can in high-return projects and return the rest to shareholders; since 2008, the majority of each company's cash flow has been returned to shareholders in the form of dividends and share repurchases.
Coca-Cola and PepsiCo returned about three-fourths of their cash flow to shareholders. Philip Morris returned more than 100% of its cash flow because it borrowed money at low interest rates and gave it to shareholders. By adding debt to its balance sheet, Philip Morris effectively borrowed future cash flow and gave it to shareholders at present -- thereby increasing shareholder value.
Philip Morris, Coca-Cola, and PepsiCo generate gobs of free cash flow and allocate it in a shareholder-friendly manner. Moreover, the companies produce cash flow today; investors do not have to make assumptions about future cash flow that the companies have not already proven capable of producing. As long as each company maintains its competitive position, shareholders can count on strong investment returns from Philip Morris, Coca-Cola, and PepsiCo.
Ted Cooper's family investment club owns shares of Coca-Cola. The Motley Fool recommends Coca-Cola and PepsiCo. The Motley Fool owns shares of Coca-Cola, PepsiCo, and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.