Geoff Gannon Investor Questions Podcast #5: Why Do You Use Free Cash Flow to Value a Stock Instead of Earnings?

The big reason why you use free cash flow to value a stock instead of earnings is that free cash flow is what companies use to do the things that add value to their stock.


Free cash flow is cash that can be used to make acquisitions, pay dividends, or buy back stock. It can also be used to pay down debt. Which is sometimes needed. But it’s not something that adds a lot of value to the stock.


So the things we want to focus on are acquisitions, dividends, and stock buybacks. Those 3 things often decide whether or not you make money in a stock.








How a stock does in the years you own it depends on how much free cash it throws off and what it does with that cash. Will it buy other businesses? Will it pay dividends? Or will it buy back its own stock?


Those are some of the most important questions to ask yourself before buying a stock. How much free cash per share is this stock going to throw off? And what is it going to do with that cash?


As an investor - you don’t have control over those things. The CEO does. So you need to know what the corporate culture is like. And what the CEO is going to do with the company’s cash.


At most companies - that’s not something you can know with a lot of certainty. But at others - like International Flavors and Fragrances (IFF, Financial), Sherwin-Williams (SHW, Financial),and CEC Entertainment (CEC, Financial) - you have a pretty good guess. All of those companies have produced free cash flow year after year. And all of those companies have taken a good chunk of that free cash flow and bought back some of their own stock. They’ve done that every year.


Some companies announce stock buybacks. A few even stick to buybacks for more than a year or two. But it’s rare for a company to lower the number of shares outstanding every year for 10 years or more. Look for companies like that. If you can buy them at decent free cash flow yields they will grow for you the way compound interest does. Instead of just paying out 6% or 8% or 12% a year - or whatever free cash flow yield you buy them at - these companies will actually grow that yield for you by reinvesting it in their own stock. And you won’t have to pay an extra tax on the cash the way you do with dividends.


Unfortunately there are other companies that are also predictable - but in a bad different way. They let cash build up on their balance sheets year after year. And no matter how much cash they have - they never feel safe. They don’t buy other companies. They don’t pay dividends. And they don’t buy back their own stock. When their shareholders complain and push them to change their ways - they agree to baby steps that don’t do much to grow the value of your stock. Avoid companies like that.


Look for companies that buy back stock. Or pay dividends. Or buy other businesses - at prices that make sense. There are some serial acquirers that do a good job. Most don’t. Big acquisitions rarely work. Small ones sometimes do. The best are companies that do lots of tiny acquisitions and don’t try to change the businesses they buy.


I’ve seen acquisitions that made sense done by companies like Consolidated Graphics (CGX, Financial), Regis (RGS, Financial), Omnicom (OMC, Financial), Danaher (DHR, Financial), and Berkshire Hathaway (BRK.B, Financial).


Some - but not all - of those companies are hands off buyers. They buy a business and then they let the old owners stay on and manage it for the new owners. All of those companies have made acquisitions part of what the company does day in and day out. Buying other businesses isn’t some once in a lifetime transformational event for these companies. They expect to buy businesses of all sizes every year. And no matter how big the deal they do today is - they expect to do an even bigger one next year.


There aren’t a lot of companies like that. Most acquisitions are done for the wrong reasons. They aren’t part of a long-term growth strategy. They are done with stock instead of cash. And they target competitors that the buyer plans to change in a thousand little ways. The best acquisitions are usually the easiest to understand. And they aren’t the ones where the buyer thinks they can do a better job of running the company than the seller. They’re usually ones where the buyer doesn’t expect to do much - or expects to do something different than what the seller focuses on day to day.


Marty Whitman - the guy who runs Third Avenue Value Fund - used to worry a lot about when to sell a stock. And he was never very good at it. But he noticed that the stocks he bought - and sold - usually ended up being bought in full by some other company. Sometimes it was a competitor. Other times it was a private equity firm. But the deal was almost always done at a much higher price.


So Whitman decided he wouldn’t worry so much about selling. He would buy the stocks. And instead of selling them - he would just let some other buyer come and take the stock off his hands. And while Third Avenue does sell a few stocks from time to time - it mostly sticks to that strategy. It buys cheap stocks. And then it lets some big buyer come in and gobble up the whole company - at a much higher price.


You can learn a lot from Marty Whitman. He has a background in bankruptcy law. And it shows. Whitman doesn’t just think in terms of what the market is willing to pay for the stocks he buys. He also thinks about the price other buyers - strategic buyers - might pay for the whole business. You should too.


If you use free cash flow to value stocks instead of earnings - you’re already thinking like someone who wants to buy the whole business. Because anyone who buys a business has to pay for that business. And they can’t use earnings. And they can’t always use stock.


A lot of times - the buyer has to use cash or debt. The cash they have on hand depends a lot on past free cash flow. And the debt they can borrow depends on the amount of free cash flow they - and the business they’re buying - throws off each year to cover interest and pay down debt.


That’s why free cash flow is so important. Because free cash flow - not earnings - is what a business uses to grow value over time. And just how much free cash flow a stock grows and how it re-plants those seeds for future years - that’s what decides the returns investors get.


I can give you a personal example of why free cash flow matters. Last year: IMS Health was the biggest position in my portfolio. A couple weeks ago I got $22 a share in cash from a private equity firm that just closed on its leveraged buyout of IMS.


When I bought the stock in early 2009 - nobody I talked to thought it was a bad company. They didn’t even think it was a bad stock. But they knew it was a healthcare stock. And they knew they didn’t want to own any health care stocks during 2009. They also asked me: “Where’s the catalyst?”. That’s Wall Street speak for: “Why should I buy such a boring stock?”


I didn’t have a good comeback. I always give the same answer: “Value is its own catalyst.” And I think that’s right. But I know I’ve never changed anyone’s mind with that line.


IMS Health was bought because of its free cash flow. The company had been using its free cash to buy back stock. It bought back some of its own shares every year for the last 10 years. And if it hadn’t been acquired - that’s exactly what it would have kept doing.


I would’ve been okay with that. When the offer came in at $22 a share in cash - I looked at the numbers and decided it was a fair offer. But it wasn’t a great offer. I’m not even sure I’d call it a good offer.


Taking a sure thing today and getting to put that cash into something else - well that works for me. But if anyone thinks $22 a share is a steal - you aren’t thinking like a long-term investor. If IMS Health had just taken its free cash flow year after year and bought back stock - there’s no way the company’s stock price could have stayed as low as the 11 to 15 dollars a share it traded at last year.


The company had so much free cash flow per share its buybacks would have shrunk the number of shares so fast the stock would have gone up. Nothing stays that cheap forever.


And that’s the lesson of Marty Whitman. And the lesson of IMS Health. Just because the market looks at earnings - doesn’t mean you have to. Outside buyers look at free cash flow. You should too.


Well that’s all for today’s show. If you have an investing question you’d like answered call 1-800-604-1929 and leave us a voicemail. That’s 1-800-604-1929.


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And as always - thanks for listening.