QUALIPORT
The Free Cash Flow Yield

By Maynard Paton (TMFMayn)
May 10, 2001

Carburton Street, London -- There are many ways to value a business. Purists argue that the only way to properly put a price tag on any business is to calculate the net present value of its future cash flows. Others, including myself, have sided with more traditional shorthand ratios, such as the price to earnings (P/E) ratio.

Both valuation methods have their problems. On the one hand, accurately predicting long-term future cash flows is notoriously difficult. And on the other, reported company earnings can be misleading. For instance, earnings may not adequately reflect, through the depreciation charge, additional capital expenditure needed to keep the business ticking over.

But is there a middle ground between the discounted cash flow calculation and P/Es? I think so.

Free cash flow

At the end of the day, it's cash profits that business owners require. More to the point, it's "free" cash they require.

Free cash flow is the measure by which a company generates cash over and above what's required to sustain its current competitive position. It funds such discretionary corporate activities as the payment of dividends, expansionary capital expenditure and acquisitions.

Free cash flow is typically defined as: Operating profit + depreciation +/- change in working capital - cash interest payments - cash taxes - maintenance capital expenditure.

However, I've never really subscribed to this calculation. For starters, timing issues cloud cash interest and tax payments. In this respect, it's always best to focus on the profit and loss account, and what tax and interest should have been paid.

But more importantly, it's best to calculate free cash flow with a view that the company has gone ex-growth. This simplifies the calculation, and as we'll see, helps to build in the all-important margin of safety into the end valuation. Taking this view, that the company has no future sales growth, allows investors to ignore working capital. All things being equal, cash presently tied up in working capital should not increase with a standstill corporate performance.

So that just leaves depreciation and "maintenance" capital expenditure, both of which, ideally, should be the same. Unfortunately, with accounting principles the way they are, the two rarely match. What's more, companies rarely separate their maintenance capital spend from their expansionary capital spend.

To keep things simple, and to punish asset-heavy companies, I tend to take all capital expenditure as maintenance spend, unless it's obvious that part of it is discretionary or for future expansion. Again, this measure helps build in a margin of safety in the resulting valuation.

So, my free cash flow calculation is defined as:

Profit before tax + depreciation - total capital expenditure - tax

Replacing the depreciation charge with the (usually higher) capital expenditure requires an adjustment to the profit before tax figure and the subsequent tax charge. It's all best explained with an example. I'll use the results from Qualiport possibility Halma (LSE: HLMA).

Year to 30th September 2000    (Łk)

Depreciation                   6,512
Capital expenditure            8,515

Profit before tax             45,902
Tax (at 31.4%)                14,415
Earnings                      31,487
Earnings per share (p)          8.72

So, replacing the depreciation charge with total capital expenditure gives the following:

Year to 30th September 2000    (Łk)


Profit before tax             43,899
Tax (at 31.4%)                13,786
Free Cash Flow                30,113
Free Cash Flow per share (p)    8.34

From this, we can say that Halma's earnings per share are 95.6% (8.34p / 8.72p) represented by free cash.

Valuation

At 128p per share, and using the above 8.34p free cash flow figure, Halma currently offers a free cash flow yield of 6.5%. Compared to the risk-free rates elsewhere, it's not a spectacular premium, given the inherent risks associated with owning any business.

Looking at the forward earnings forecasts, which Halma have recently confirmed as being in line with their own expectations, we can produce a prospective free cash flow yield. Current forecasts suggest earnings per share of 9.35p in the current year, which converts, at 95.6%, into a free cash per share figure of 8.94p. So, at the current 128p share price, Halma offer a prospective free cash yield of 7.0%.

Margin of safety

But what is an acceptable free cash flow yield that incorporates a significant margin of safety? With base interest rates now at 5.25%, would 8% be acceptable? I think so. Putting that into context with Halma, its share price would have to fall to 112p to offer an 8% prospective free cash flow yield.

But remember, that calculation also builds in two other safety features: that future sales and profits remain flat, and that all capital expenditure is effectively written off.

However, those two features would create a generally disappointing investment scenario for long-term Halma shareholders. Halma's management have a long record of reinvesting the company's free cash to generate above average shareholder returns. Nevertheless, if my implied sub-standard performance was actually to happen, and Halma's management couldn't find suitable reinvestment opportunities, prospective shareholders should still receive a return on their investment through increased dividends or share buy-backs.

Summary

Of course, for this and any other valuation measure, investors require stable and predictable businesses, run by rational managers that have a proven record of reinvesting shareholders' cash at superior rates of return.

However, the free cash flow yield nicely entwines the benefits of the discounted cash flow and those of shorthand valuation measures.  Requiring a high free cash flow yield focuses the investor's eye on the cash and capital expenditure needs of a company, while ensuring that most essential of investing tenets is also sought: obvious and immediate value.