The previous article Part 1, points out that valuation is often the missing link to successful investing. Think about the conversations you have with fellow investors. Usually, the price of a stock gets mentioned, but rarely is the value.
Investor Joel Greenblatt is a very successful professional investor. His firm, Gotham Capital, generated annualized returns of 40% from 1985 to 2006. His refreshingly simple definition of investing is “to figure out what a business is worth and pay a lot less.”
Price is what we pay, and value is what we can expect to get back. Just as price is important, investors need to estimate the value so they can “pay a lot less.” Valuation is used to calculate the worth of a business (so we can know what we should pay.)
Valuation the Missing Link
In Part 1, we discussed comparative valuation methods using the financial ratios; Low Price to Book (P/B), Low Price to Earnings (P/E), and a Low PEG ratio (Price to Earnings Growth).
We continue with four more comparative valuation ratios; Low Price to Free Cash Flow (P/FCF), Low Enterprise Value to EBITDA (earnings before interest, taxes, depreciation, and amortization) or EV/EBITDA, Low Price to Sales (P/S), and Above Average Dividend Yield.
A Low Price to Free Cash Flow ratio (P/FCF)
Free Cash Flow is the amount of cash flow leftover, or free, for discretionary spending. It is determined by taking operating cash flow from the cash flow statement and subtracting maintenance capital expenditures.
For example, if the company’s operating cash flow is $100 million and it must spend $25 million each year to maintain its capital assets (property, plant, and equipment), it’s Free Cash Flow is $75 million.
Free Cash Flow is the additional cash remaining after the company paid expenses. It is “free” for discretionary spending. Discretionary spending can be used to expand the business or return money to shareholders.
When compared to earnings per share (EPS), free cash flow is a more direct measure of the ability to produce profits. That is because there are fewer accounting adjustments in the cash flow calculations than in earnings.
A robust Free Cash Flow indicates a promising future. And, combined with a low share price usually makes a good investment. Investors can consider FCF more critical than other measures because of its transparency and more direct relation to stock prices.
Free Cash Flow also considers the amount of Maintenance Capital to provide a more transparent comparison between capital intensive and less capital intensive businesses.
A low Price to Free Cash Flow, or its reciprocal Free Cash Flow Yield, is one of the most useful ratios. Price to Free Cash Flow gives a clear view of a firm’s ability to generate cash available to shareholders.
The inverted P/CF is the free cash flow yield.
Using Price to Free Cash Flow
Does the Price/Free Cash Flow multiple Work?
S&P 500 14 Year Study
In a 14 year backtest summarized in the table below, 20 percent of the S&P 500 stocks were ranked by the P/FCF and placed in five quintiles. The lowest P/FCF multiple placed in the first quintile and the highest in the fifth quintile and the portfolios rebalanced every 12 months.
The results are clear. The first quintile outperformed the fifth quintile showing annualized returns more than twice as high. The cumulative returns over the fourteen years were six times as high.
Peter George Psaras Study
Another study by fund manager Peter George Psaras illustrates the power of the P/FCF multiple. The study used 60 years of the Dow Jones Industrial Average (1950 – 2009).
Each January 1st, the Free Cash Flow Portfolio purchased companies in the Dow Jones Industrial Average (DJIA) with a P/FCF of around 15 times. They were held for exactly one year and sold on December 31st. This process was repeated for sixty years and compared to the DJIA (the DJIA portfolio).
The results show that a Free Cash Flow based strategy not only works but was astounding. The FCF Portfolio beat the DJIA in fifty‐five of the sixty years tested. The average gain for the FCF Portfolio was +21.1% per year over sixty years, compared to an average increase of the DJIA Portfolio of +6.8% per year.
Starting with $10,000 in each of the portfolios (FCF vs. DJIA), after sixty years, the DJIA would be worth $511,470 and the FCF portfolio worth $965,001,511. The FCF method beat the DJIA by 1887 times, or in relative performance terms, by 188,700%. So much for index investing.
Using Price to Free Cash Flow
Based on the above studies, a P/FCF of <15 (or an FCF Yield >7%) should produce more than satisfactory results over a 3-5 year investment horizon. Price to Free Cash Flow remedies the valuation as the missing link.
The Limitations of Price to Free Cash Flow
Free Cash Flow is Operating Cash Flow (OCF) less the Maintenance Capital Expenditures (Capex) required for the ongoing business. However, Maintenance Capex is often not separated from Total Capex. Approximations of Maintenance Capital are necessary in these cases to calculate Free Cash Flow.
Zacks 10-year Study with Operating Cash Flow
Zacks ran a 10-year study ending in late 2013 with Operating Cash Flow. They found annual returns were correlated. Here to, the Price to Operating Cash Flow multiple showed convincing results:
So, even if the Maintenance Capital is not readily available, Operating Free Cash Flow can also provide a good indication of value and remedy valuation as the missing link..
Many investors are unfamiliar with cash flow ratios, their calculations land interpretations. Part of the reason is there are several different measures of cash flow that lead to confusion.
For example, the two discussed above are Free Cash Flow and Operating Cash Flow. However, the exact cash flow measure used gets shortened in writing or conversation to the simple term “cash flow.” The only way to know for sure is to ask, which cash flow?
Those limitations considered, the Free Cash Flow ratio is one of the best relative valuations in my view. That is because of the transparency and consideration for the capital required to maintain the cash flow. And it works well.
The Price to Free Cash Flow ratio is worth the effort to find, clarify, or calculate if not readily available.
A Low Enterprise Multiple (EV/EBITDA)
The Enterprise Multiple or EV/EBITDA ratio compares Enterprise Value (EV) to the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
EV is Enterprise Value, which includes the firm’s equity value (or stock market capitalization) and the firm’s debt less any cash.
EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization. It is an approximation for cash flow.
EV/EBITDA is useful in comparing firms in the same industry with different debt levels.
The ratio’s reciprocal shows the cash return on the total investment in the company, including both the equity and the debt.
Using EV/EBITDA
The EV/EBITDA is usually readily available or calculated with publicly available information. So it is widely used and discussed in the investment community.
The EV/EBITDA multiple is most useful in comparing companies within an industry group taking both the equity and debt investment into account.
It works well for valuing stable, mature businesses with low capital expenditures.
Analysts will also use this multiple to express the target price of a company in equity research reports.
And, it is useful for comparing private company transactions to publicly traded deals of similar companies.
It is also used to calculate the terminal value in a Discounted Cash Flow DCF model that we’ll discuss later.
The Limitations of EV to EBITDA
Limit the use of EV/EBITDA to comparisons of companies in the same industries or sectors. The limitation is because capital expenditures but not considered in EV/EBITDA.
And because it doesn’t consider capital expenditures, EBITDA is not representative of cash flow. However, it is another useful tool to help solve the valuation as the missing link problem.
Low Price to Sales (P/S)
The Price to Sales ratio measures the value that investors place on the business in comparison to the revenue generated by the company.
The Price to Sales defined as the ratio of the stock market price of the company’s shares divided by its sales per share. Or, the company’s market capitalization divided by its total sales.
A low price to sales ratio may indicate the company’s stock is undervalued. And, a high ratio relative to its sector may indicate an overvalued company.
The total sales are on the income statement. And, the total number of shares outstanding is either on the income statement or in the notes section of other reports. The sales are usually the last twelve months, next twelve months or the trailing twelve months (TTM)
The Price to Sales ratio may approximate the future valuation of companies that do not yet to generate income or cash flows.
Using Price to Sales
P/S Is most useful for startup companies or ones facing hardships and not generating positive income or cash flow.
If the company’s startup or turnaround is successful and generates profit margins similar to its industry peers, the P/S ratio provides an approximation of value.
However, the big implicit assumption is the company will someday generate similar sales, margins, and, therefore, earnings and cash flow as their more profitable peers.
The Limitations of Price to Sales
A big assumption is the company will eventually generate margins and earnings equivalent to its peers, perhaps before it has demonstrated the ability to do that.
Do not use the P/S ratio to compare companies in different industries or sectors. Different industry profit and margin characteristics will render the comparison meaningless.
The P/S ratios do not consider the company’s debt or balance sheet. A company with little debt will be more attractive than a highly levered company with the same P/S ratio.
The Price to Sales ratio is the most indirect and tenuous solution to valuation as the missing link and used with caution.
P/S may provide useful guidance when valid industry or sector comparisons exist.
Above Average Dividend Yield
Legendary investor Geraldine Weiss popularized a simple and successful valuation method known as the Dividend Yield Theory (DYT). It is useful with high-quality, stable dividend stocks because they tend to fluctuate around a dividend yield.
The stable dividend and relatively stable stock price create a dividend yield that tends to fluctuate around the company’s underlying fair value.
The idea is to buy when a high-quality stock is within 10% of the highest historical dividend yield or the highest in the past five years. That occurs when the share price drops relative to the dividend paid, and the stable dividend’s yield increases as the share price falls.
Then sell when the dividend yield is within 10% of the lowest historical dividend yield or the lowest in the last five years. That is when the stable dividend paid yield decreases as the share price rises.
Share price deviations from the fair value change the dividend yield. And it will eventually revert to the mean because of the stable nature of the company. The Dividend Yield Theory is a useful tool to solve the valuation as the missing link.
Limit The Dividend Yield Theory use to high quality “blue chip” stocks. This valuation method is covered further in the “Dividend Yield Valuation” section of Dividend Growth Investing Valuation Part 4 here.
What we Learned:
- Valuation is the missing link to successful investing.
- Comparable ratios can provide relative valuations.
- It is important to use companies in the same industry.
- Price to Free Cash Flow ratio (P/FCF) is a beneficial ratio.
- P/FCF is transparent and considers the capital required to maintain the cash flow.
- Enterprise Value to EBITDA multiple (EV/EBITDA) is available and widely used.
- EV/EBITDA takes both the equity and debt investment into consideration.
- The Price to Sales (P/S) ratio measures the value investors place on business revenue.
- P/S approximates future valuation in the absence of income or cash flow.
- Dividend Yield Theory is useful with high-quality Dividend Growth stocks.
- DYT assumes reversion to the mean, and the dividend yield represents the fair value of the stock.
We’ll discuss estimating intrinsic value with discounted cash flow analysis in the next post on valuation.
References
- S&P 500 Price to Free Cash Flow Backtest
- Back‐test showing the power of Price to Free Cash Flow in the Investment Process
- Zacks 10-year Study with Operating Cash Flow
Valuation is the Missing Link – Part 1