Wednesday, May 14, 2008

It's Free-Cash-Flow Stupid!, Part II

Finding a company with strong free-cash-flow is great. This is a beginning of evaluating a company and let me assure you, it's certainly not the end. What a company does with the free-cash-flow is something that I want to watch closely. Some of the companies will be very reckless and go for stupid acquisitions, diversifying into some unrelated businesses, playing the stock market, etc. Many of the small caps companies have these problems. It's probably will do more harm to your portfolio than anything else if you start buying based on my yesterday post.

Once I find a company with strong free-cash-flow, I will look for Return on Equity(ROE), to satisfy myself whether the management is doing a good job with the money. Good management will do one or a combination of the following four things:

(i) plow back the money into the business. A highly profitable one will be manifested in good ROE or ROIC. Parkson is a good example.

(ii) pare down debts. Tenaga was doing that but don't buy the company just for this reason.

(iii) buy-back shares below its intrinsic value and not at any price!

(iv) in a mature industry with very slow growth, returning money to shareholders is very common, so that investors are free to reinvest in other higher returns companies.

Let's pick a company that we are familiar: Nestle. The table below is the financial information. Will you want to pay for 10x P/BV, 22 times PE, 4.5% earning yield for 4-5% earning growth and Free-Cash-Flow yield of 4%. ROE is excellence: more than 50%, that is because they return almost all the money to you. However, since they retain so little earnings, you cannot enjoy the compounding power despite of high ROE. Re-read the last sentence again, this is the secret of ROE that nobody wants to teach you and me.

If you discount all the free-cash-flow perpetually, according to an analyst, Nestle worth about $ 28/share. Based on my own calculation, I would probably will want to pay up to $ 26, discount all the FCF at 7%. Why 7%? For me, it's a return expectation that I am getting by putting money into a bond fund.

To be a value investor, the word value is already implying you need to have some valuation skills to determine value of a stock. If we cannot determine the value of a stock, how do we know a stock is undervalued? Even someone have done a valuation for you, you need knowledge and skills to interpret the results. It is not as simple as looking at PE, P/BV, FCF yield, etc.

You need multiple valuation models for different kind of situations. It is not as simple as buy when a stock is plunging like sh***(Transmile example). I will spend a bit of time to write about Graham's dogs over the weekend.

If this sound too frustrating to you: adopt index investing, it will beat most of the professionals ( click to see my other entry: Common Sense About Dollar Averaging).

After I buy Parkson, I am going to put FBM30-etf into my portfolio just to demonstrate my will to go for a simple approach.

P.S. A note to Nestle shareholders, please don't sell your stock after reading this post. You will still probably will get a decent 8-10% CAGR returns over a long period of time.

1 comment:

Liana S said...

hi would like to ask you a question. is that a company with higher FCF will also have higher EVA and MVA itself. appreciated if you could explain this..thanks!