After 15 years of study and practice, I believe one of the secrets to long-term investing success is to buy companies generating high and growing free cash flow at attractive prices and then hold those companies for a long time.
Luckily for us, there is one metric that captures the essence of this strategy: free cash flow yield. Let me explain.
Companies with the ability to grow free cash flow per share will be worth more in the future. As investors, we should aim to buy these companies at attractive multiples of free cash flow (calculated as a ratio of stock price to free cash flow) today. (For a primer on free cash flow, click here.)
To make relative valuation easier, I recommend inverting the price/FCF multiple to calculate a company's FCF yield, which is a rough estimate of expected annual return. Thinking in terms of yield allows investors to compare a stock's FCF yield to the risk-free rate (the yield on the 10-year U.S. Treasury bond), to the yields of other stocks and bonds, and to the yields from investing in real estate (a real estate's cap rate is calculated as annual net cash flow divided by the purchase price of the property).
All else being equal, whether you are dealing with stocks, bonds, or real estate, higher yields indicate cheaper purchase prices.
Because using FCF yield allows investors to easily compare the attractiveness of one investment to another, some of the greatest investors in the world use it as their primary valuation metric.
The following three quotes come from the excellent book The Art of Value Investing by John Heins and Whitney Tilson.
"The reason we have do at least cursory work on 100 companies per year is that it is really hard to find the three or four that in addition to the 10 percent free-cash-flow coupon [yield], can also generate growth in free cash flow of at least 10 percent per year. ... If we can buy 10 percent current coupons and if the coupon grows at 10 percent, the math says we will generate an annual 20 percent unlevered return."
--Jeffrey Ubben, ValueAct Capital
"We then estimate the percentage of those normal earnings that the company will keep after things like capital spending and investments in working capital, resulting in a free cash flow number we can divide by the current market value to get a free cash flow yield. On top of that we'll add inflation and the annual growth in free cash flow we expect in order to arrive at our estimated rate of return, which we typically want to be at least in the teens."
--Stephen Yacktman, Yacktman Asset Management
"We look at free cash flow yield plus expected growth in free cash flow, compared to the market-implied rate of return. Take Amazon: the free cash flow yield is around 5 percent, but the free cash flow growth rate is 20 to 25 percent easy. So that's a 30 percent free cash flow total return versus, at most, the 8 to 10 percent you'll get on the overall market."
--Bill Miller, Legg Mason
In each of the above quotes we can see the importance of investing in companies with "growing" free cash flow trading at attractive FCF yields.
That begs the question: What is an attractive yield?
Typically my answer is 10%. A 10% FCF yield (equivalent to a P/FCF ratio of 10) provides an appealing long-term investment opportunity when compared to the risk-free rate on a 10-year U.S. Treasury bond, which has averaged about 6% over the past 50 years. Using the S&P 500 as a proxy, 10% is also the approximate long-term annualized return of the stock market. Therefore stock investors should shoot for a rate of return of at least 10%.
However, with today's risk-free rate near historical lows between 2% and 2.5%, investors should consider lowering their required rate of return -- that is, they should be willing to pay slightly higher multiples of free cash flow (which is the same as accepting slightly lower FCF yields). As a general rule, aim to buy stocks when their FCF yield is at least 1.5 times higher than the yield on the 10-year U.S. Treasury bond.
Another quick, back-of-the-envelope method to determine whether a company's shares are attractively priced is to compare the company's long-term average return on equity to its P/FCF multiple. (This is a trick I learned from Jason Donville, president and CEO of Donville Kent Asset Management.) If the company's return on equity is at least 1.5 times higher than its P/FCF multiple, you may have found an attractive buying opportunity. Let's look at an example.
In February of 2013 Berkshire Hathaway and 3G Capital announced that they were acquiring Heinz. The risk-free rate at the time was about 2%.
At first glance, it appeared Warren Buffett was paying a rich price. Based on the purchase price of $72.50 per share and Heinz's free cash flow per share at the time of about $3.32, Buffett and his partners were paying about 22 times free cash flow. That works out to about a 5% FCF yield (3.32/72.50 = 4.6%). This was about 2.5 times higher (5/2 = 2.5) than the risk-free rate at the time -- pretty darn good!
Further, because of the way Buffett structured the deal, Berkshire Hathaway was guaranteed a minimum 6% annual return on its investment. Buffett invested $12 billion into Heinz -- that's $4 billion in common stock and $8 billion in preferred stock that paid a 9% dividend. If we multiply the 9% by the $8 billion of preferred, we see that Berkshire was guaranteed $720 million in annual dividends. Then, if we divide the $720 million by Berkshire's total investment of $12 billion, we see that Berkshire is guaranteed a 6% annual return at a time when the risk-free rate was only 2%.
Buffett negotiated a deal that provided Berkshire's shareholders with a return three times higher than the risk-free rate, making his acquisition of Heinz look downright cheap, given the low-interest-rate environment.
Finally, let's see how the FCF multiple of 22 paid by Berkshire and 3G compares to Heinz's return on equity. At the time of the acquisition, Heinz had averaged 42% ROE over a 10-year period. If we divide 42 by 22 (ignore the percentage sign and just divide the whole numbers), we see that Heinz's ROE was about two times higher than the P/FCF multiple, which is higher than the 1.5 times minimum threshold I mentioned earlier in the article. This indicates that Buffett and 3G acquired a high-quality company at an attractive price.
It is true that Heinz's ROE had dropped to 31% at year-end 2012, but 3G Capital are masters at cutting costs, improving margins, and boosting returns. The high likelihood that 3G Capital would be able to improve Heinz's free cash flow (based on 3G's past successes) makes the purchase price that Berkshire and 3G paid even more attractive.
As you can see, FCF yield is a simple but effective metric that can help investors both big and small make smart and successful investments, so I highly recommend you add this tool to your valuation belt today.
Note: Some of the above analysis on the Heinz deal structure was first published in "Taking Heinz Private" by Joseph Calandro in Journal of Private Equity. I served as a research assistant on the article. If you want a detailed analysis of the modern Graham and Dodd approach to valuing Heinz, I highly recommend you read the article. You can find a copy of the article at the Gabelli Center website. Joe Calandro is a Managing Director at PriceWaterhouseCoopers and the author of Applied Value Investing, as well as over 30 articles in scholarly journals. He is also a friend, mentor, and master of valuation.
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