I've read most of your articles on GuruFocus and am going over lots on your website… I was wondering if you can offer some insight into valuing a Canadian company, Tim Hortons (THI). I have used your intrinsic value calculation based on average 10-year FCF and a Shiller P/E multiplier. My guess is that there is more expected growth in the company's future and thus it trades at a higher multiple to FCF. Is there something that is better suited to determining a rough share price based on intrinsic value for this company other than FCF? If a company is investing much of FCF into expansion and thus not lending itself to the intrinsic value analysis based on FCF is there a better way? I'm not positive it is a growth company but it seems to make sense given a higher valuation...
First of all, you’re right about there being a difference at Tim Hortons between free cash flow and earnings. I’m looking at a 5-year comparison of the stock’s price-to-earnings and its price-to-free-cash-flow (you can graph this at GuruFocus). If you look at the P/E – around 12 – everything looks wonderful. But the price-to-free-cash-flow – around 50 – looks pretty scary. Last year, Tim Hortons’ depreciation and amortization charges were $118 million – all dollars are Canadian – while cap-ex was $132 million. So cap-ex is higher than depreciation. And it has been that way for years. In fact, the gap seems to be shrinking. Cap-ex beyond depreciation was much higher a couple years back.
Finally, there are some non-operating items in Tim Hortons’ earnings. So anyone reading this article should know they shouldn’t rely on the reported net income – or P/E numbers – they see at most websites. Go to EDGAR and read the company’s 10-K for yourself.
Now, moving from the specific company you asked about – Tim Hortons – to the general issue you raised…
Isn’t free cash flow – the way I calculate it – a crazy way to value a business?
Yep. You got me. It is crazy. Especially when it comes to valuing growth companies. Especially companies that put out money today to make money tomorrow. Companies like Tim Hortons.
But is there a better number to use than free cash flow?
The right way to value a company is really "owner earnings" rather than free cash flow. This is Warren Buffett's concept. And basically it means that a company is worth its cash flow from operations minus the capital expenditures necessary to maintain the company's current level of sales, profits, etc. This is the idea of "maintenance cap-ex" you hear so much about.
By the way, the same is true of changes in working capital. If a company is constantly growing inventories, receivables, etc. by 15% a year because it is also growing sales by 15% a year this increase in current assets is not a concern. If, however, the company is increasing inventories, receivables, etc. by 15% a year while sales grow by only 10% a year you can rightly worry that maybe not every dollar of reported earnings is being quickly turned into actual free cash flow. With capital expenditures this is tricky.
How much is the right amount?
Your example of Tim Hortons is a tough one because it is a business like retail, restaurants, etc. that depends somewhat on how the place looks to keep customers coming in. Even grocery stores after 20 years of so-so upkeep start to look in need of a face lift. Maybe the aisles are too narrow for the current style. Maybe there isn't enough light. The flooring is not what people have become accustomed to nowadays. And so on. Over time this means that some of the cap-ex is needed to reinvigorate the company and some is needed for growth.
I mention this because retail and restaurant chains sometimes have a period of very fast growth. At the time, it seems like a lot of the cap-ex is going into growth. Because it's going into new locations. But what if new locations start by looking great but say 10 years later they really start looking out of date? They aren't in any way impaired physically. They've been properly up kept. But there's a need for a new look. It's not as if every McDonald’s (MCD) has looked the same for half a century. There are constant little adjustments at chains. Logo changes, color schemes, etc. But also making a place airier or lighter or having exposed ductwork or whatever.
Why even bring this up?
Because it illustrates the problem of separating capital spending for future growth versus capital spending for present maintenance. In a sense, capital spending on new locations is growth and capital spending on old locations is upkeep. But is that sense right? What if the same level of sales can be achieved using the same stores? Then we could definitely call that level of capital spending “maintenance cap-ex”. But what if renovating old locations could lead to a jump in sales? Well, then, that would be growth capital spending even though the cash is being spent on an "old" location.
The way Warren Buffett likes to think about the cash flow question is to think about "owner earnings". If a company produces a certain amount of cash during the year, how much would the owner need to send back to that company's management for them to keep sales, profits, etc. the same next year and next year and next year. Can we imagine a sort of "steady state" of capital spending that would keep profits about the same in the future as they are today.
If so, that is the correct number to use. That's the number you subtract from cash flow from operations to get free cash flow. You want "owner earnings" to make your intrinsic value calculation. Not free cash flow the way I measure it.
So, why do I measure free cash flow as cash flow from operations minus capital expenditures?
Because it's an exact number. It's a number where I can point to the statement of cash flows and show you how I got it.
It's not perfect. It's not even best. But the best number is owner earnings. And owner earnings is necessarily an inexact amount. It's an estimate. Based on whether you think the current level of capital spending is maintaining the earning power of – in this case – the entire chain at the same level from year to year.
Use owner earnings. Make an estimate. That really is best. But, remember, when a company's stores are all brand new and sparkling it's not just easy to achieve growth at new locations. There's a halo of clean, new, stylishness that the entire chain enjoys. And so same store sales benefit too.
When stores get old – the reverse is true. It’s not just a lack of spending on new stores that you’ll start noticing. It’s a lot of outdated old stores – and possibly falling same store sales – that you’ll see.
In other words, if a growing chain is really knocking it out of the park in terms of same store growth and chain wide sales growth at the same time it is really spending big on its cap-ex – you need to know that both of those numbers are probably higher now than they will be in the future (per store). But remember that both are probably too high. Don't assume that a decade from now same store sales growth of 6% a year will still be happening if today same store sales growth is 6% and the average store age is really, really young.
Just because you can't precisely quantify something doesn't mean you shouldn't think about it. It is best to consider what industry, societal, economic, and company specific headwinds or tailwinds a company faces today. And it's always a good idea to study past examples from the same industry. So if you are studying a new, fast growing restaurant you should learn everything you can about McDonalds, and Starbucks (SBUX), and Chipotle (CMG), and a thousand other examples from both the long ago and quite recent past.
Generally, I would suggest trying to find an investment where a performance that is only average compared to the way other companies in the same situation – in their own past – performed would still give you good results. Ideally, the company would appear to be as well positioned or better positioned than past examples of growth in that industry were in their heyday.
What you don't want is to think that a growing company can produce as much free cash flow as a mature company or that a mature company can grow as fast as a young company. You need to be realistic in the way you look at a company's cash flow needs and opportunities for growth.
Great companies can grow revenues without needing to use much cash to do it.
Good companies can grow revenues as long as they grow the amount of cash they're spending on growth.
Bad companies need to increase cash spending even when they are not increasing sales.
The worst companies are those that have to spend more just to stay in place.
None of this is exactly quantifiable. All of it is important.
I recommend reading Phil Fisher's "Common Stocks and Uncommon Profits" along with some of Warren Buffett's thoughts on the subject. I'd start with his shareholder letters. Especially those from the 1980s. I think the letter where he talks about “owner earnings” is the 1987 letter to shareholders. Combine that with Phil Fisher and you'll have a good idea of what matters for growing companies. Sometimes what matters is hard to measure.
So we have to estimate things like owner earnings. That doesn't mean owner earnings is less important than free cash flow. It isn't.
It's just less exact.
Talk to Geoff About Free Cash Flow vs. Owner Earnings [email protected]