Cash Flow: An Equalizing Force in Analysis

 Executive Summary

  • The use of valuation metrics are a central element of Heartland’s 10 Principles of Value Investing™.
  • Cash flow analysis allows investment managers to cut through differences in accounting practices and capital intensity to unearth compelling opportunities.
  • In our view, price/cash flow is a useful complement to traditional valuation measures like price/earnings and price/book.

Cash flow analysis can be a powerful tool in evaluating stocks but it takes a nuanced approach for investors to leverage the full strength of the measure.

In its basic form, price/cash flow ratio (P/CF) allows investors to compare opportunities on a level playing field, because cash flows are insulated from variations in accounting methods that influence other metrics like earnings or book value. We view the ratio as an important starting point in evaluating businesses.  By adding additional layers, we’ve made it more robust at exposing variations in capital intensity required to produce streams of revenue across sectors.

Because P/CF is calculated using operating cash flow, it doesn’t include capital expenditures (cap-ex). Critics point to this as a weakness because the ratio is agnostic toward the amount that must be spent by a company to generate revenue. To that point, heavy industrial companies often come across as considerably cheaper than those in less investment intensive areas such as Information Technology (IT). To adjust for this, we use free cash flow when comparing names across industries because it accounts for spending for equipment and other reinvestments into the business.

When evaluating companies that have low cap-ex requirements but higher debt, we add another wrinkle to the equation. In these situations we look at free cash flow/enterprise value (FCF/EV). Given enterprise value includes debt and liabilities, this ratio is useful to judge relative cheapness of a company as well as its ability to pay for an acquisition.

Cash Flow Analysis in Action

The varying versions of cash flow analysis may seem better suited for an academic setting, but the following example of two names we’ve looked at illustrates how they can have real life implications in investment decisions.

WEC Energy Group, Inc. (WEC) is a utility operating primarily in Wisconsin and Illinois. FMC Technologies, Inc. (FTI) designs and manufactures equipment and provides services for energy companies.  We’ve chosen these companies to show how cash flow analysis can be used to compare businesses that have different investment needs and operate in very different areas of the market.    

The power company’s share price was $58.79, while FMC’s was less than half at $27.70. Estimates for WEC’s fiscal 2016 earnings per share stand at $2.92, translating to a forward 2016 price/earnings (P/E) of 20.1x. We expect FMC Technologies to earn $1.24 per share during the same period, resulting in a forward 2016 P/E of 22.3. Looking at these two companies solely on P/E, it appears that WEC is more attractively valued.

Rolling up Our Sleeves

To get a more complete picture of which is a more compelling opportunity, we want to strip out the effects of accounting policies on each name. For that we turn to a simple P/CF ratio. WEC’s estimated $2.0 billion in operating cash flow translates to a P/CF of 9.7x compared to FMC’s estimated ratio of 12.2x on operating cash flow of $682 million. Using this measure WEC again appears to be more attractively valued. But what this simple analysis misses is the significant capital expenditures the utility requires to generate revenue.

When reinvestment costs are subtracted from the equation, free cash flow for WEC is reduced to just $592 million and the P/FCF ratio jumps to more than 31.4x. The impact of reinvested capital is far less for FMC with free cash flow edging down to $490 million and a P/FCF multiple of 12.8x. Using this analysis, FMC is revealed to be significantly less expensive and we believe is the more efficient opportunity.

As a final check, we look at FCF/EV. The inclusion of debt and liabilities in the calculation provides a more accurate yield, in our opinion, and prevents companies from being rewarded for recent debt-financed expenditures. On this measure, FMC again appears to be the more attractive with a yield of more than 7.5% versus 2% for WEC. This suggests FMC generates greater resources to pay off its debt, buy back stock or make accretive acquisitions than does WEC.

Comparing WEC and FMC
  WEC Energy Group, Inc. FMC Technologies, Inc.
Share Price $58.59 $27.70
Earnings Per Share (forward 2016) $2.92 $1.24
Price/Earnings (forward 2016) 20.1x 22.3x
Price/Cash Flow 9.7x 12.2x
Price/Free Cash Flow 31.4x 12.8x
Free Cash Flow/Enterprise Value Yield (forward 2016 2.0% 7.5%

Source: Bloomberg L.P. and Heartland Advisors, Inc., as of 4/15/2016

By working through multiple layers of cash flow analysis, we were able to compare two different opportunities in distinct sectors in a way that provided a deeper understanding of which was trading at a more attractive valuation. While P/CF is just one of our 10 Principles of Value Investing™, we believe it is a foundation to our bottom-up approach to investing.

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Heartland Advisors Value Investing Portfolio Manager Colin McWey

Colin McWey

McWey, CFA, is Vice President and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He has 14 years of industry experience, 7 at Heartland.

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