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.
Heartland Advisors Value Investing Price to Cash Flow IconIn 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 Health Care. 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 dividends, repurchase shares or fund acquisitions.

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. Omnicom Group Inc. (OMC) is a New York-based marketing and communications company. 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 $79.52 as of May 14, while Omnicom’s was at $78.73. Estimates for WEC’s fiscal 2018 earnings per share stand at $3.51, translating to a forward 2019 price/earnings (P/E) of 22.6x. We expect Omnicom to earn $5.86 per share during the same period, resulting in a forward 2019 P/E of 13.5x. Looking at these two companies solely on P/E, it appears Omnicom is more attractively valued, however a closer look is warranted.

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 $2.1 billion in operating cash flow translates to a P/CF of 12x compared to Omnicom’s estimated ratio of 9.7x on operating cash flow of $1.8 billion. Using this measure bolsters our initial view that OMC appears to be the more attractive opportunity. But what this simple analysis omits is the significant capital expenditures the utility requires to generate revenue.
When reinvestment costs are subtracted from the equation, free cash flow for WEC turns negative with the company generating negative free cash flow of -$329.1 million making the P/FCF ratio negative. The impact of reinvested capital is far less for Omnicom with free cash flow edging down to $1.6 million and a P/FCF multiple of 10.9x. Using this analysis, Omnicom 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, Omnicom again appears to be the more attractive with a yield of 7.9% versus –1.0% for WEC. This suggests Omnicom generates greater resources to pay off its debt, buy back stock or make accretive acquisitions than does WEC.
Comparing WEC and Omnicom Group
  Heartland Advisors Value Investing Energy Sector Icon
WEC Energy Group, Inc.
Heartland Advisors Value Investing Consumer Discretionary Sector Icon
Omnicom Group Inc.
Share Price $79.52 $78.73
Earnings Per Share (forward 2018) $3.51 $5.86
Price/Earnings (forward 2018) 22.6x 13.5x
Price/Cash Flow 12x 9.7x
Price/Free Cash Flow (forward 2018) -76x 10.9x
Free Cash Flow/Enterprise Value Yield (forward 2018) -1.0% 7.9%

Source: Bloomberg L.P. and Heartland Advisors, Inc., as of 5/14/2019

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 17 years of industry experience, 10 at Heartland.

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