Executive Summary

  • The use of valuation metrics are a central element of Heartland’s 10 Principles of Value InvestingTM.
  • 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.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.

Disclosure:

Past performance does not guarantee future results.

Investing involves risk, including the potential loss of principal. There is no guarantee that a particular investment strategy will be successful.

Value investments are subject to the risk that their intrinsic values may not be recognized by the broader market.

As of 3/31/2016, Heartland Advisors on behalf of its clients held approximately <0.01% and 0.00% of the total shares outstanding of FMC Technologies, Inc. and WEC Energy Group, Inc., respectively. Statements regarding securities are not recommendations to buy or sell. Portfolio holdings are subject to change. Current and future holdings are subject to risk.

The statements and opinions expressed in this article [or appearance] are those of the presenter(s). Any discussion of investments and investment strategies represents the presenter’s views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed above, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations are based on Heartland Advisors’ estimates. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change.

Sector and Industry classifications as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems, Inc. or the Global Industry Classification Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

Definitions: 10 Principles of Value Investing™ consist of the following criteria for selecting securities: (1) catalyst for recognition; (2) low price in relation to earnings; (3) low price in relation to cash flow; (4) low price in relation to book value; (5) financial soundness; (6) positive earnings dynamics; (7) sound business strategy; (8) capable management and insider ownership; (9) value of company; and (10) positive technical analysis. Book Value: is the sum of all of a company’s assets, minus its liabilities. Earnings Per Share: is the portion of a company’s profit allocated to each outstanding share of common stock. Enterprise Value (EV): is the entire economic value of a company. Free Cash Flow: is the amount of cash a company has after expenses, debt service, capital expenditures, and dividends. The higher the free cash flow, the stronger the company’s balance sheet. Price/Book Ratio: of a company is calculated by dividing the market price of its stock by the company's per-share book value. Price/Cash Flow: represents the amount an investor is willing to pay for a dollar generated from a particular company's operations, shows the ability of a business to generate cash, and acts as a gauge of liquidity and solvency. Price/Earnings Ratio: of a stock is calculated by dividing the current price of the stock by its trailing or its forward 12 months’ earnings per share. Price/Free Cash Flow: compares a company's market price to its level of annual free cash flow. Price/Operating Cash Flow: compares a company's market price to its level of annual operating cash flow.

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