For the value guys: What sort of FCF/F yields do you look for?

The PM I have been working with demands a 10% yield on normalized FCF (CFO-Capex) yield... implicitly, less than a 10x FCF multiple.

How about you guys?

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Comments (29)

Sep 16, 2014

Apparently this guy named Warren paid around 10x for stakes in KO/USB/AXP/BNI

http://brooklyninvestor.blogspot.com/2014/03/10x-p...

Sep 16, 2014

Also I don't think of "unadjusted" and "normalized" being pari passu. Normalized FCF typically adjusts for aberrant working capital movements, transaction related fees, non-recurring restructuring charges, etc. Those who incorporate more macro views will even normalize interest rates, market cycles, economic growth, etc.

To finally add something helpful:

-If I think something isn't really growing but the business isn't going away I'd be happy with a 13%-15% normalized FCF yield.

-If a business is growing at around a GDP type rate I'd be happy with a 10% FCF yield

-If a business is growing fast (ie double digits) and is well managed, I'd be happy with a 6-8% FCF yield.

I would also define "normalized FCF" as EBITDA less maintenance CapEx. Hopefully growth CapEx is non-recurring and will yield tangible benefits to shareholders in the future, much like dividends or buybacks.

Buffet is rich because he paid 10x pre-tax earnings for businesses that were growing far faster than GDP and well-stewarded. Who knows when we'll see those kind of opportunities again. Chances are the next time stocks are that cheap a lot of people will be shitting their pants.

    • 3
Sep 17, 2014
Gray Fox:

I would also define "normalized FCF" as EBITDA less maintenance CapEx. Hopefully growth CapEx is non-recurring and will yield tangible benefits to shareholders in the future, much like dividends or buybacks.

You mean NOPAT less maintenance CapEx?

Sep 17, 2014

No. If you do NOPAT - maint. CapEx you're double counting the 'maintenance capex' because of the D/A effect. Also, pre vs post tax, but that depends on the user.

Sep 17, 2014

How do you differentiate maintenance vs growth CapEx?

Sep 17, 2014
oaktree capital:

How do you differentiate maintenance vs growth CapEx?

One grows the business (gets bigger), one maintains it (stays the same size). [insert sarcastic comment making you feel stupid]

Sep 17, 2014
Gray Fox:

Buffet is rich because he paid 10x pre-tax earnings for businesses that were growing far faster than GDP and well-stewarded. Who knows when we'll see those kind of opportunities again. Chances are the next time stocks are that cheap a lot of people will be shitting their pants.

Funded by cheap float to boot.

    • 1
Sep 16, 2014

Who is Warren Buffett?

He is on my doesn't exist list.

Oct 6, 2014
DickFuld:

Who is Warren Buffett?

He is on my doesn't exist list.

Who else is on that list besides Hank?

Sep 16, 2014
superandy241:
DickFuld:

Who is Warren Buffett?

He is on my doesn't exist list.

Who else is on that list besides Hank?

Timmy and Dubya.

Sep 16, 2014

Thanks for the insightful post, I made a mistake. I should have been more clear. If the business is normalized, then unadjusted FCF would be normalized... if that makes sense (and the price was right).

My posts will be fraught with grammatical errors since I post from my phone. I will try my best not to post an incoherent babble.

Sep 18, 2014

I get the comparability issues. But that's more for conducting a relative valuation comparison versus an absolute one . Pre-tax FCF is obviously an easier calculation, but in the end taxes are real cash costs and need to get factored into FCF. The easiest solution is to use a pre-tax simple FCF calculation, like EBITDA less maintenance capex, and then revise upward your FCF required yields given they are pre-tax (see Gray Fox's thresholds above, then adjust them upward a bit).

Best Response
Sep 18, 2014

OK so firstly, saying that OCF - CapEx (or maint CapEx) must exceed 10% for any company in any market is utterly nonsensical. There's a good chance your PM is a dunce, who will unfortunately stay in business because this nonsensical rule will probably work more often than not over time.

Secondly, from a valuation standpoint, you need to focus on UNLEVERED free cash flow. why is this, you might ask? The answer is (among other things) because a 10% levered FCF yield on the same company implies a massively different enterprise value if that company has 5x of debt versus zero debt. This is so impossibly elementary, and yet there are literally dozens of thousands of pretenders eating the golden crumbs of 2/20 who simply are incapable of understanding (or caring) about this fact. There are companies and capital structures and markets where a 10% levered FCF yield is way too expensive, and companies and capital structures and markets where a 10% levered FCF yield is the deal of the millenium.

Thirdly, EBITDA-CapEx is not free cash flow. It's EBITDA-CapEx. There's a time and a place for that, but it's not when you're calculating fcf yields. As an obvious example, the same company domiciled in the US vs Canada, trading at the same multiple of EBITDA-CapEx, looks a heck of a lot different on an fcf yield basis because the Canadian corporate tax rate is 14% lower than the US tax rate.

Fourthly, to calculate unlevered FCF, the quick and dirty is to look at normalized EBIT * ( 1 - Tc), plus D&A, less norm CapEx, +/-Chg in Working Capital. Working capital can be a non-factor, or it can be a huge factor, depending on what the company looks like, how it is growing, etc. To be more specific you need to consider the difference between D&A and CapEx because the difference between the two matters from a cash flow standpoint.

Fifthly, stripping out maintenance CapEx can be useful, but remember that you are implicitly assuming that FCF will no longer grow, and as such you have to capitalize the business at a lower multiple of that FCF to establish a price target

    • 5
Sep 16, 2014
RLC1:

OK so firstly, saying that OCF - CapEx (or maint CapEx) must exceed 10% for any company in any market is utterly nonsensical. There's a good chance your PM is a dunce, who will unfortunately stay in business because this nonsensical rule will probably work more often than not over time.

Secondly, from a valuation standpoint, you need to focus on UNLEVERED free cash flow. why is this, you might ask? The answer is (among other things) because a 10% levered FCF yield on the same company implies a massively different enterprise value if that company has 5x of debt versus zero debt. This is so impossibly elementary, and yet there are literally dozens of thousands of pretenders eating the golden crumbs of 2/20 who simply are incapable of understanding (or caring) about this fact. There are companies and capital structures and markets where a 10% levered FCF yield is way too expensive, and companies and capital structures and markets where a 10% levered FCF yield is the deal of the millenium.

Thirdly, EBITDA-CapEx is not free cash flow. It's EBITDA-CapEx. There's a time and a place for that, but it's not when you're calculating fcf yields. As an obvious example, the same company domiciled in the US vs Canada, trading at the same multiple of EBITDA-CapEx, looks a heck of a lot different on an fcf yield basis because the Canadian corporate tax rate is 14% lower than the US tax rate.

Fourthly, to calculate unlevered FCF, the quick and dirty is to look at normalized EBIT * ( 1 - Tc), plus D&A, less norm CapEx, +/-Chg in Working Capital. Working capital can be a non-factor, or it can be a huge factor, depending on what the company looks like, how it is growing, etc. To be more specific you need to consider the difference between D&A and CapEx because the difference between the two matters from a cash flow standpoint.

Fifthly, stripping out maintenance CapEx can be useful, but remember that you are implicitly assuming that FCF will no longer grow, and as such you have to capitalize the business at a lower multiple of that FCF to establish a price target

How is that rule nonsensical? As I understand it, there are three, conventional ways to measure "cash flow."

Levered FCF (free cash flow to equity): NI + D&A + debt issuance - mandatory debt repayment - change in working capital - Capex;

FCF: CFO - Capex; and,

Unlevered FCF: you covered this.

Also, don't you think an assessment of leverage would be covered in a sound investment process? I think you were overzealous in your answer and focused on ridiculing posters in this thread rather than being helpful.

My posts will be fraught with grammatical errors since I post from my phone. I will try my best not to post an incoherent babble.

Sep 18, 2014

I look at unlevered FCF margins and levered FCF yields. Why? Because an unlevered FCF margin tells me how good the fundamental business is (leverage doesn't change that). On the other hand, I look at levered FCF yields (so levered FCF divided by market cap) to see how cheaply a company is trading. Sure you could also look at unlevered FCF divided by enterprise value, but I find levered FCF divided by market cap is a slightly quicker calculation. At the end of the day, once I determine a business is fundamentally sound and FCF generative, I then want to see how much FCF actually gets generated. Here leverage plays a role because more debt means greater interest expense which means less FCF generated, so there is left cash left over for organic growth, dividends, share buybacks, debt paydown, etc.

    • 1
Sep 18, 2014

one2three:

- What you are calling "levered FCF (free cash flow to equity)" is not a useful calculation. If you removed debt issuance, it could become a somewhat useful calculation if for example you were reviewing a business where there was some concern that the company would be able to service its debt/cover its fixed charges. With the debt issuance included, this is little more than an incomprehensive "change in cash" calculation.
- What you are calling FCF is actually levered FCF. This is the amount of free cash flow that accretes to equity value (whether or not it is entirely distributable).
- Unlevered FCF: as discussed
- I think a sensible investment process would exclude silly rules like "must have 10% levered FCF yield" for all the reasons previously mentioned. I post on this website periodically exclusively to be helpful. Sometimes being helpful entails explaining why other comments are incorrect

Basketball banker:

- Unlevered FCF margins is a rube goldberg version of just looking at normal margins (gross, ebit/da/r/x, etc). And normal margins and and of themselves have some information content, but in a vacuum you really can't conclude that a business is good or bad based on margins alone. For example, I am currently looking at a short run value-added distrubution business that has sub-10% EBITDA margins and sub-20% gross margins. I guess this would likely yield an unlevered FCF margin in the 5% - 6% range. Seems low right? Well - Not if you consider that at any given time there is only ~1.5x EBITDA of invested capital in the business. The company is a free cash flow machine and won't take much capital to grow. On the other hand, if you build an elevator to the moon at a cost of $10 trillion, and sell trips up at a 98% ebitda margin that yields $50 million/year of gross profit... well that is a shitty business.

- Looking at levered fcf yields doesn't comprehensively tell you whether or not a company is cheap for the reasons i previously mentioned. Buying the same company at the same price, where one has a higher levered fcf yield, means that all else being equal, the one with the higher levered yield will have a higher return, BUT NOT A BETTER return. Stated differently, adding leverage to a business can increase equity IRRs, but it does not increase the value of the business.

    • 1
Sep 16, 2014
RLC1:

one2three:

- What you are calling "levered FCF (free cash flow to equity)" is not a useful calculation. If you removed debt issuance, it could become a somewhat useful calculation if for example you were reviewing a business where there was some concern that the company would be able to service its debt/cover its fixed charges. With the debt issuance included, this is little more than an incomprehensive "change in cash" calculation.

- What you are calling FCF is actually levered FCF. This is the amount of free cash flow that accretes to equity value (whether or not it is entirely distributable).

- Unlevered FCF: as discussed

- I think a sensible investment process would exclude silly rules like "must have 10% levered FCF yield" for all the reasons previously mentioned. I post on this website periodically exclusively to be helpful. Sometimes being helpful entails explaining why other comments are incorrect

Basketball banker:

- Unlevered FCF margins is a rube goldberg version of just looking at normal margins (gross, ebit/da/r/x, etc). And normal margins and and of themselves have some information content, but in a vacuum you really can't conclude that a business is good or bad based on margins alone. For example, I am currently looking at a short run value-added distrubution business that has sub-10% EBITDA margins and sub-20% gross margins. I guess this would likely yield an unlevered FCF margin in the 5% - 6% range. Seems low right? Well - Not if you consider that at any given time there is only ~1.5x EBITDA of invested capital in the business. The company is a free cash flow machine and won't take much capital to grow. On the other hand, if you build an elevator to the moon at a cost of $10 trillion, and sell trips up at a 98% ebitda margin that yields $50 million/year of gross profit... well that is a shitty business.

- Looking at levered fcf yields doesn't comprehensively tell you whether or not a company is cheap for the reasons i previously mentioned. Buying the same company at the same price, where one has a higher levered fcf yield, means that all else being equal, the one with the higher levered yield will have a higher return, BUT NOT A BETTER return. Stated differently, adding leverage to a business can increase equity IRRs, but it does not increase the value of the business.

If you ever have the time, review this.
http://www.youtube.com/watch?v=av4FDxLcyNw&list=UU...

My posts will be fraught with grammatical errors since I post from my phone. I will try my best not to post an incoherent babble.

Sep 17, 2014

i agree with your comments in philosophy, but i would assume that (knowledgeable) investors would base frame their fcf yield valuation in the context of roic/quality of business.

Oct 6, 2014

NOPAT margins will tell you a lot. A valuation where the NOPAT margin yields a ROIC WACC cannot be saved by higher growth/reinvestment.

Sep 18, 2014

so whilst the statement that instances where "[incremental] ROIC WACC cannot be saved by higher growth/reinvestment" is true, that statement has nothing to do with NOPAT margins. Stated differently, NOPAT margins do not yield (i) valuations; (ii) ROIC; or (iii) WACC. NOPAT margins insufficiently account for the capital intensity of the business, per my previous low nopat margin-high roic, and high nopat margin-low roic examples. Thus this metric is, in a vacuum, not particularly useful

Sep 16, 2014

I was gone for two weeks and missed the finance 101 lecture

OK so firstly, saying that OCF - CapEx (or maint CapEx) must exceed 10% for any company in any market is utterly nonsensical. There's a good chance your PM is a dunce, who will unfortunately stay in business because this nonsensical rule will probably work more often than not over time.
-I never said any company in any market. I would consider a company growing at a GDP type rate with a 10% FCF yield as an exceptional investment (ie the kind you find 2-3 times a year if you are lucky.

Secondly, from a valuation standpoint, you need to focus on UNLEVERED free cash flow. why is this, you might ask? The answer is (among other things) because a 10% levered FCF yield on the same company implies a massively different enterprise value if that company has 5x of debt versus zero debt. This is so impossibly elementary, and yet there are literally dozens of thousands of pretenders eating the golden crumbs of 2/20 who simply are incapable of understanding (or caring) about this fact. There are companies and capital structures and markets where a 10% levered FCF yield is way too expensive, and companies and capital structures and markets where a 10% levered FCF yield is the deal of the millenium.

-I know the difference between unlevered FCF and levered FCF. Any moron that takes a few finance classes or gets to CFA 2 knows how to get to both figures (and the appropriate denominator to use). I generally invest in companies with little debt. I posted a few rules of thumb.

Thirdly, EBITDA-CapEx is not free cash flow. It's EBITDA-CapEx. There's a time and a place for that, but it's not when you're calculating fcf yields. As an obvious example, the same company domiciled in the US vs Canada, trading at the same multiple of EBITDA-CapEx, looks a heck of a lot different on an fcf yield basis because the Canadian corporate tax rate is 14% lower than the US tax rate.

-Agreed

Fourthly, to calculate unlevered FCF, the quick and dirty is to look at normalized EBIT * ( 1 - Tc), plus D&A, less norm CapEx, +/-Chg in Working Capital. Working capital can be a non-factor, or it can be a huge factor, depending on what the company looks like, how it is growing, etc. To be more specific you need to consider the difference between D&A and CapEx because the difference between the two matters from a cash flow standpoint.
Fifthly, stripping out maintenance CapEx can be useful, but remember that you are implicitly assuming that FCF will no longer grow, and as such you have to capitalize the business at a lower multiple of that FCF to establish a price target
-Finally, if my PM is a dunce I hope to be 1/10th of a dunce one day.

Sep 16, 2014
Oct 6, 2014

Interesting post. Subscribed.

Oct 7, 2014

Enjoying the discussion so far. I'd be interested to hear how you account for acquisition heavy businesses. I'm not particularly fond of companies that growth through acquisitions, but it's a bit of a question mark for me in terms of analysis.

For example, you've got a company that has to pay R&D and cap ex every year to keep its business running and drive some organic growth. Then every couple years or so there is a large acquisition. This obviously makes FCF look like it's growing nicely, since the additional cash flow is included, but the acquisition costs are not. In this case, they are very similar to growth cap ex. Sure you can look at the multiples/yield involved for each acquisition, but when there are several through the years and they are all building towards an integrated product offering, then how do you look at it?