How do investors retrieve FCF?
Hi to everyone!
It could be a stupid question, but I just don't get it: how do investors retrieve FCF? I mean, all valuation is based on FCF — ok, we have FCF: +100 this year, what does it give to investor? It only means that company holds +100 in cash on its bank account, but to retrieve it, company should issue dividends — investor just can't come and retrieve cash.
What do you think? I think I am just missing something very easy, but I don't understand what exactly.
Thank you!
First of all, recognize that FCF does not mean cash in the bank for the company. Typically in a DCF you are using unlevered free cash flows, which ignore interest expenses and interest tax shields, as well as any cash flows related to financing.
So unlevered FCF of $100 for a company with $20 of interest expense may translate to $100 - 20 + 8 = $88 of levered, or equity, free cash flow, assuming no principal payments are made to debt holders and a 40% tax rate.
It is really up to management to decide where FCF goes, so investors don't have much immediate say in the matter. But cash flow could really be used to a) reinvest in the business (beyond projected capex included in the FCF number), b) pay principal on debt or preferred securities, c) return cash to equity holders via dividends/repurchases. Or, it could just sit on the balance sheet as cash in the bank, or more likely in short-term securities.
For what it's worth, this sounds like a stupid question but I think it's a legitimate thing to consider - valuation via DCF is fixated on unlevered free cash flows, but what management does with those cash flows can have a huge effect on value. A company which utilizes all of its FCF to buy back shares when the stock price is low or otherwise issue dividends is going to have FCF translate to shareholder value at a much higher rate than a company like Apple, where most of it sits on the B/S.
I actually think this is a fairly intelligent question for someone new to valuation.
Ultimately all valuation comes down to generating cash for investors, whether in the short-term (through dividends and share repurchases) or long-term (reinvesting cash in the business to increase future cash flows). But OP is correct that just because a company generates cash, it doesn't necessarily mean that investors will receive any cash. The question is whether the Company's strategy is appropriate -- ie it makes a lot of sense for high growth potential companies to reinvest cash, but it doesn't necessarily make as much sense for mature companies in mature industries.
A lot of investors will buy companies on cash flow but may have to take a more activist role to actually reap the benefits.
Extelleron and mrb87, thank you for your comments! I think I started to understand the concept of utilizing FCF. But one more thing came in mind to me: we usually estimate Cost of Equity via CAPM/Dividend growth. Let's consider the following scenario: company doesn't make any dividends, so we estimate cost of equity via CAPM and it's about 13% (doesn't really matter). Ok, we have Cost of Equity — the return on equity investment in a company. Company produces stable positive FCFE, which goes back to company as a reinvestment. And all this happens for years. But company is a market leader, its potential is obvious and it is considered as a good investment. Yes, it is private.
In this case we have the following: investor invested in company which doesn't pay anything back to investor, but according to theory, investor requires the return. How is that possible?
Thank you!
The "required return on equity" you get via CAPM or other models is really a theoretical concept. Ignore the CAPM or specific stocks for a moment, and imagine you are planning for retirement today and going to buy a whole-market index fund to hold for the next 40 years. You'd want to have an idea of what kind of returns you could expect - not in any given year, but over the long-haul - from your investment. To get a sense of those returns, you'd look back to past market returns and see that the average equity return has been ~8% per year. So you would now expect a return of 8% per year, on average, over the next 40 years.
The CAPM gives you the same kind of figure, just risk-adjusted for a company's market exposure and taking into account current risk-free rates. It should be thought of as a long-term expected return from the investment.
As an equity investor, you will only get physically paid through dividends, special payouts upon liquidation/sale of the company, or through selling the shares to other investors. A company which does not pay dividends still produces returns because, assuming management is reinvesting the cash in investments with good returns, the ability to pay future dividends increases. Moreover, the value of the company to a private investor has increased, meaning it could be sold for more than before - and you as an equity holder would have claim to your piece of the pie if the company were sold. Berkshire Hathaway has never paid a dividend - it has only reinvested in the business or repurchased shares - but it is highly valued based on its ability to pay future dividends or to be sold to a private investor at its current valuation.
I'd say just think of it as if you owned the whole company yourself, and never paid yourself dividends but reinvested in the business year after year: cash flows would be increasing year after year, and you'd be able to either pay yourself dividends in the future or sell the business. Assuming you were requiring a 10% return and were able to reinvest at 15%/yr, you'd be better off never paying yourself dividends. Even if you needed income in the meantime, you'd be better of selling some of your stake in the company rather than paying dividends - the same concept is true of a public corporation if you are a shareholder.
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