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Free Cash Flow Isn't Everything

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Geoff Gannon
May 09, 2012
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Someone who reads my articles asked me this question:


I know Warren Buffett looks for companies with good returns on capital. So, I recently calculated Wal-Mart's return on invested tangible assets. I used a normalized free cash flow number and the invested tangible assets are based on the most recent fiscal year results.

The ROITA I get for Wal-Mart (WMT, Financial) is 6.46% — normalized FCF of 10,745 divided by tangible invested assets of 166,205.

You recently told me that your minimum acceptable level for this measure is 10%. So, why in the world would Warren Buffett continue to own WMT stock with this terrible ROITA number?



Warren Buffett is interested in a company's return on net tangible assets.

I’ve never heard Buffett say exactly how he calculates “unleveraged return on tangible equity.”

But I can give you a pretty good approximation. It’ll work for almost any company. And it has the added benefit of focusing you on the business rather than how the company is financed.

The best approximation of unleveraged return on tangible equity — for Buffett — is probably something like:

EBIT/(Receivables + Inventory + Property, Plant and Equipment) - (Accounts Payable + Accrued Expenses)

Wal-Mart’s Return on Investment

I'll use the 2011 and 2012 numbers for Wal-Mart. We'll average them:

Receivables: $5.089 billion and $5.937 billion averages out to $5.51 billion

Inventory: $36.318 billion and $40.714 billion averages out to $38.52 billion

PP&E: $107.878 billion and $112.324 billion averages out to $110.10 billion

Accounts Payable: $33.557 billion and $36.608 billion averages out to $35.08 billion

Accrued Expenses: $18.701 billion and $18.154 billion averages out to $18.43 billion

So, Wal-Mart’s average net tangible investment last year was: ($5.51 billion + $38.52 billion + $110.10 billion) - ($35.08 billion + $18.43 billion)

Which works out to $100.62 billion. This is a lot less than your estimate of $166 billion in invested tangible assets.

That’s because it’s the net investment that matters. Some of those assets are offset by current liabilities — payables and accrued expenses — that Wal-Mart does not have to pay interest on.

These liabilities don’t cost shareholders anything. And they allow Wal-Mart to finance over $50 billion in productive assets.

Without this ability, retailing would be a pretty lousy business. There are a few exceptions. Some retailers can make money even if they paid everyone instantly. But that’s not usually the case. And, luckily, no one expects instant payment.

If you look at Wal-Mart’s net tangible investment – you’ll notice it’s not working capital. The stuff they aren’t funding through current liabilities is all really property, plant and equipment.

Many companies that compete with Wal-Mart do not own as much PP&E as Wal-Mart does. They lease it.

The same rule applies here that I mentioned with Copart (CPRT, Financial) in an earlier article. Although Wal-Mart is an inferior business to Copart from a pure ROI standpoint, it’s still earning good returns on its investment.

Whether you are earning 17% on your unleveraged tangible equity or you’re earning 27% on your unleveraged equity (Copart is closer to 27%) — you’re obviously earning way, way more than the kind of unleveraged returns folks make by owning real estate.

So the fact Wal-Mart owns a ton of its properties is interesting. It’s worth noting. But is it a good reason for increasing your estimate of what the business is worth?

Wal-Mart may be a safer investment because it owns property. But it isn’t necessarily a more valuable business.

Why not?

Because Wal-Mart’s properties are being put to better use inside the Wal-Mart system than they would be if they were sold to someone else.

By counting the company’s earnings, you are already valuing the real estate at its best use.

That doesn’t necessarily mean Wal-Mart couldn’t operate more efficiently by owning less of its properties. But we’re really talking about financing here. It’s the same discussion we’d be having if we were asking whether someone should borrow at 5% for 30 years simply because they can arrange that today. Maybe they should. But it’s not a business discussion. It’s a finance discussion.

Let’s leave corporate finance out of this for now.

Wal-Mart’s EBIT last year was $26.56 billion. So, that's $26.56/$100.62 = 26.40% pre-tax return on net tangible assets. Assuming about a 35% tax rate, this would leave Wal-Mart with a normal return on unleveraged tangible equity of about 17%. This is probably an accurate estimate of the company’s earning power.

So, why do you get such a low number when you calculate the company's return on invested tangible assets?

Well, for one thing you use free cash flow. Free cash flow is good. But some value investors focus on it too much. The idea is to build wealth over time. Usually, a business that produces free cash flow is going to compound wealth quite well compared to a business that doesn't.

And, personally, I have some doubts about Wal-Mart's long-term ability to sustain its ROI. I am much more negative on all retailers with physical locations than most people. Amazon (AMZN, Financial) has such a clear future. And it is not a good future for guys with stores.

I would not invest in retail stores. We obviously have too many of them in the U.S. We have too much offline retail capacity. This is not good for the long-term returns in the retail business.

Anything that can ship, doesn’t spoil quickly, and doesn’t need to be bought every few days to a week — anything like that is something where Amazon can eventually beat you both on price and definitely on customer experience.

Unless you are a grocery store or Nebraska Furniture Mart — eventually Amazon is going to hurt you a lot.

Target (TGT, Financial) and Wal-Mart are going to lose ground to Amazon over time.

So I have more doubts about their future ROIs than a lot of investors do. These companies reinvest a lot. So, it’s kind of a huge question for shareholders to ponder — what kind of returns on investment will I be getting in 2022? This stuff matters.

But if you have reason to believe a dollar retained by a business is worth as much as a dollar paid out to you — and in Wal-Mart's case it clearly is for now — then why would you prefer free cash flow to retained earnings?

If a company makes $1 and it retains that $1 and it increases next year's earnings by 15 cents because it retained that $1 — isn't that $1 better off in the company's hands than it would be in your hands? Do you really think you will — on average — make more than 15 cents for every dollar of dividends you get from a company?

Most investors will make nowhere near 15% on the money they themselves invest. If they manage to make 10% a year — starting today — over the long term, I will be surprised. Stocks are not priced for double-digit returns.

So, reinvestment in businesses with sustainable double-digit ROIs is a better place for your money than dividends paid into your brokerage account.

I know a lot of people don’t feel that way — they always like dividends better — but the math is the math. If you can’t earn 10% and the companies you own can — you should leave your money with them. Not ask for it back.

Warren Buffett is interested in compounding his wealth — not necessarily in free cash flow. He has often bought businesses that generate more cash than they can redeploy. This is an unfortunate fact. He'd rather find companies that can redeploy that capital. But it's not easy. It's usually much, much easier to find a company that earns a high return on its unleveraged tangible equity than it is to find a company that earns a high return on its unleveraged equity and can increase the size of that tangible equity meaningfully over time.

That's not easy. And so Berkshire has often had to redeploy capital from great businesses that can't use a lot of capital growth to somewhat less great businesses that can use a lot of capital growth. That tends to be the pattern. It is hard to find businesses that generate high returns on capital and can continue to reinvest in their business for a long time.

The first number you should look at when you're worried about return on invested tangible assets is:

EBITDA/(Receivables + Inventory + PP&E) - (Accounts Payable + Accrued Expenses)

This tends to put companies on even footing. If you can go back 15 to 20 years or so and find the range of that number, the median, etc. and how much of these EBITDA tends to be converted into net income and/or free cash flow you will have a very good idea of how profitable a business it is.

Now, Buffett himself disparages EBITDA. And he’s not wrong to do that. EBITDA is definitely not net income (or free cash flow).

But this is a complicated issue. Buffett is thinking about something called owner earnings. Well, free cash flow is not owner earnings. If you only count the cash that is generated after a company grows, you will be punishing companies that grow 10% a year so severely that you will pass on many good, growing businesses simply because they are growing.

That's not a good idea.

So Buffett may not like EBITDA. But he doesn’t pay a lot of attention to reported earnings either. You want to get at the economic reality of the situation. Something like owner earnings. Which is basically EBITDA minus what you need to grow the business (both in terms of cap-ex and additional working capital).

So, it’s okay for some companies not to produce a lot of free cash flow.

Having said that, it’s only okay if they are earning good returns on their investment. Really good returns. When in doubt, err on the side of actual free cash flow today over dreamt of profitable growth tomorrow.

You need to see a gap between the return on net tangible investment the company tends to earn - in my view the long-term median figure is more useful because reliability is key and high ROIs are really only interesting to the extent they are backed up by consistency or moats — and the hurdle rate you have for your own investments.

If you think you can make 10% a year in your own investments, then it does not make sense for you to invest in companies that are earning less than let's say 15% a year after-tax on their unleveraged tangible equity. Without a gap like that, it’s hard to see why you would prefer retained earnings to paid out earnings.

A dollar paid out to you can be reinvested — we'll ignore taxes here for a minute — at let’s say a 10% return. This is not a guarantee. I think making 10% a year may be harder today than most investors think. The number you can actually make is probably lower (I’d say no more than 7%). But it’s definitely not higher — for investors as a group — than 10%.

The value of money depends on the rate you can compound it at. So, a dollar in your pocket can compound at 10%. Well, if a dollar in Wal-Mart's pocket can't compound by more than 15% a year — we have a problem. Several actually.

The problems are:

1. You probably know yourself better than Wal-Mart

2. Wal-Mart's past is probably better than its future will be

3. Net income probably overstates owner earnings

To sum these points up: No margin of safety.

Generally, if you are investing in a business for its profitable future growth you want that future growth to be something like 150% of the annual growth you think you could provide using the same money. This extra 50% provides you with a margin of safety in your future compounding.

Now, of course, that is not enough. You also want to focus on businesses where you feel the ROI is not only high but reliable.

Reliability is key.

So, if you think Dun & Bradstreet (DNB, Financial) has a very reliable business, than DNB at 12 times earnings or 9 times enterprise value divided by EBITDA — or whatever — is a lot more attractive than some other businesses trading at the same multiples. It's like the difference between a safe bond yielding 6% and a very risky bond yielding 6%. They both offer the same return — in theory. Yeah, they pay the same amount this year. But, they do not both offer the same reliability.

Over time, the more reliable return will compound better than the less reliable return.

So, you want to find a company with an ROI that is — I would say — at least 1.5 times the return on investment you yourself think you can achieve. And you want that ROI to be as reliable as possible.


The most reliable ROIs tend to be in businesses built around a habit. A cigarette company has a highly reliable ROI. Starbucks has a highly reliable ROI.

Sure, they can screw things up. Any business can. But if you go to the same Starbucks every morning you’ll notice everybody’s brain is on auto-pilot. There is not a conscious decision being made in that store.

Other things equal, that’s the kind of business to bet on. One where the customers don’t think. They just do.

A habit is usually the best way to insulate a customer from competition. Habits are the first line of defense in business. When you lack a habit (which is the best — most personal form of customer protection) you have to rely on less effective competitive strategies like defending an entire market from entry.

To use an analogy, this is like protecting a VIP with a perimeter instead of a bodyguard. I’m not saying it can’t work. I’m just saying it’s not the only strategy to consider.

Industry-wide defenses are often the only competitive strategies economists and investors talk about. But such a wide defense is far from ideal. It's really a fall back plan for when direct defense of customers is prohibitively expensive.

The best businesses often have more direct defenses like:

  • Defending specific customers (we will retain the P&G account, we will be the place where Bob gets his morning coffee)
  • Defending specific locations (we will dominate the Omaha furniture market, we will dominate the West coast boxed chocolate business)
  • Defending specific times (we will account for the majority of U.S. box office on the 1st weekend of May, we will get a large number of sci-fi fans into theaters on one weekend in February)

Durability: Warren Buffett Style

As you know, Warren Buffett basically invests in two kinds of businesses:

  1. Those with pricing power
  2. And those with low costs
In theory, both of these kinds of businesses are better insulated than most businesses when it comes to the damage done to them by the idiocy of their competition. Mistakes made by competitors are most dangerous when your prices, costs, and customers are similar to those competitors. If you and your competitor have different prices, costs, and customers - you are obviously going to be harmed less than if you share these 3 things.

One reason I don't like the cell phone business is that I think companies tend to share these three things — potentially — if not actually. I think a hit phone has rather similar economics to different companies. And I feel customers are definitely willing to entertain the idea of switching phones (much more so than say carriers).

The point is that these qualitative factors combine with a quantitative margin of safety to give you a certain view of a company's return on investment.

In the case of Wal-Mart, I think Warren Buffett believes the company's domestic business has low costs. And it has a reliable ROI because of those low costs. Basically, it can operate profitably at gross margins where its competitors can not.

Obviously, I'm less comfortable with Wal-Mart than Warren Buffett is. I personally am buying more and more things from Amazon that I used to buy from Wal-Mart (and I literally pass a Wal-Mart on the way home from work — so that’s a pretty clean test of my shopping preferences).

Here’s my problem. Over the next five years, Wal-Mart's customers will increase purchases from Amazon at a faster rate than they will increase purchases from Wal-Mart.

I’d be willing to make that bet today.

When your best customers are flirting more and more frequently with a competitor — that’s an awful sign.

Buffett is a lot more comfortable with retailers than I am. I feel their competitive advantages can vanish pretty fast. Now, he tends to focus on some very specific retailers like Nebraska Furniture Mart that are pretty unique. They sometimes have very big cost advantages. He doesn't usually buy retailers for any other reason besides big cost advantages.

So I'm sure he calculates Wal-Mart's return on investment as being in the teens and being very reliable. That is why he likes the stock.

Also, he is getting a good earnings yield. That is critical.

Your return in a good business — if you hold it forever — is going to depend on:

  • Growth
  • Return on Investment
  • Earnings Yield
In other words:

· What quantity of earnings are you purchasing today?

· How much room is there for reinvesting those earnings in the future?

· And what will you earn on those reinvested earnings?

That's what Warren Buffett cares most about. Not just how much a company is earning today. He cares about the value of the earnings they retain.

He wants every dollar of retained earnings to be worth more than a dollar. Not less.

Now, obviously, buying Wal-Mart's earnings today is not very expensive.

For every $1 you pay, you get 7 or 8 cents of earnings.

That may not sound like a lot. Don't many companies trade around 13 times earnings?

But it's the reliability of that equity "coupon" that Buffett is getting in Wal-Mart and the belief that each dollar of reinvested earnings will be worth at least a dollar.

So, you are buying a 7% or 8% bond with a safe coupon and low reinvestment risk. That is how Buffett sees Wal-Mart.

That's an attractive combination.

Bought: Dun & Bradstreet

I bought Dun & Bradstreetyesterday for the same reasons.

The earnings yield is now high enough to justify an investment. I think it has a safe equity "coupon." And I think the reinvestment risk is low. Basically, you are buying something that yields around 10% in terms of normal free cash flow where I think whatever earnings they retain will not be worth less than it would be if they didn't retain it.

It's the same logic Buffett applies to Wal-Mart.

I should point out that while DNB’s free cash flow is high — it would definitely not be worth less to me if that free cash flow was lower. In fact, I’d love for DNB to have the opportunity to produce less free cash flow while reinvesting more earnings in its core business.

But it can’t. The prospects for reinvestment at DNB are absolutely minimal.

Free Cash Flow Is Not Everything

That’s not the end of the world. It’s not like Berkshire has grown See’s a lot in real terms.

If you can retain customers, raise prices, and not add capital to a business — you can make a lot of money without having much real growth.

The fact that these businesses need very little additional investment to expand is good. But the fact they aren’t expanding is bad. You’d always rather a highly profitable business was growing.

Buffett would’ve loved to take See’s cross country. If he did that, it would’ve had less free cash flow for a while. But the business would’ve been worth more over time.

Coke (KO, Financial) is a brand that travels. See’s is not. Coke is certainly not worth less because it invests in growth. It is only worth less to the extent it invests in growth that doesn’t add more value than you could using the same money in your own brokerage account.

So, don’t just look at free cash flow and assets.

Look at earnings and net tangible assets.

In the future, if you want to understand Buffett's investment decisions I'd start by looking at:

EBIT/(Receivables + Inventory + PP&E) - (Accounts Payable + Accrued Expenses)

Rather than just Free Cash Flow/Total Assets.

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