The fundamental factor I place more weight on than any other when conducting investment analysis is cash. In business, cash is king. It is also one of the metrics that is tough for a company to manipulate or fake.
You can manipulate profits through income statement adjustments, but it is almost impossible to manipulate cash flows without actually inventing the figures. A company with a cash-rich balance sheet will never have any balance sheet problems. Cash gives a company flexibility to invest for the future and reward shareholders at the same time.
What’s more, and this is probably the single-most important deciding factor for me when making an investment decision, a company with a strong cash balance or cash generation is not dependent on capital markets for survival.
Dependent on capital markets
Businesses that have high levels of debt and cannot finance themselves are reliant on the kindness of financial markets to keep the lights on.
Whether it be through debt or equity issuance, or even revolving credit facilities, companies that rely on these avenues for funding will find themselves in a sticky situation if the economic environment turns, sentiment toward the industry sours or investors start to question the company’s long-term financial position.
If the company is reliant on capital markets and investors begin to question whether or not it can survive, the doubts become a self-fulfilling prophecy.
Cash outperforms
My love of cash means I will usually value a company based on its cash ratios, such as free cash flow yield and cash flow to price, as well as gearing and cash conversion ratios. This approach has helped me avoid any severe losses over the years, and a recent research note from analysts at Bernstein’s Global Quantitative Strategy team confirms free cash flow is one of the best ways to value businesses.
According to the report, using free cash flow to value businesses is the best performing metric regarding both returns and low volatility. The report notes free cash flow is proving to have “impressive risk-return profile in every region” but “without the volatility.” In addition to these benefits, the ratio appears to work in a variety of situations, including “when macro visibility is low, or stock correlations are high.” Moreover, “free cash flow yield gives an enviably smooth performance risk-adjusted through the cycle that beats all other key styles.”
The data behind this conclusion is difficult to fault. Analysts at the Wall Street investment bank have run a backtest going back to 1991 across different geographical regions. Initially, the analysis was looking for correlation trends between investment styles. Free cash flow stood out.
All regions showed positive results, but Asia excluding Japan produced the best returns with an annualized gain of 9.08% and a 12.27% standard deviation. The lowest volatility with higher returns was seen in Europe where an annualized return of 6.16% was reported with a standard deviation of 7.83%.
The best returns
The Bernstein report goes on to note what we already know; the companies with the highest free cash flows tend to have the best cash return policies for shareholders. Robust free cash flows can be used to buy back stock, pay dividends to investors and fund organic as well as bolt-on growth. These factors are bound to help stable cash flow businesses outperform weaker small cash flow peers.
The bottom line
Overall, free cash flow is one of the best metrics to value a business. It is also one of the best ways to get to grips with a company’s potential. Free cash flow will tell you if the company is dependent on debt to function, and how much capital is available for redistribution to shareholders going forward. This is one metric that should be included in every investor’s investment analysis.
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