ROIC and FCF - BFA.docx

ROIC and Free Cash Flow In this module, I want to talk to you about ROIC and free cash flow, two metrics that are very important to investors. But I want to start with the second one first. A company is worth the sum of the future cash flows it generates. We call that the intrinsic value. But here's...

ROIC and Free Cash Flow In this module, I want to talk to you about ROIC and free cash flow, two metrics that are very important to investors. But I want to start with the second one first. A company is worth the sum of the future cash flows it generates. We call that the intrinsic value. But here's what's interesting. A company is not worth the sum of its future profits. That's a misnomer. And here's why. Let's say, on a personal level, you buy a car, a brand new car right off the lot, and you're going to keep this car for 10 years. But you don't do any maintenance on the car for 10 years. I'm telling you, the car is not going to last 10 years. Well, the same is true for a company. If I invest in a company and that company doesn't take any of its profits and reinvest in itself, the company's going to fall apart. So the company's going to have to take some of those profits and reinvest just to sustain what it has. And then, if it wants to grow, it's going to have to take some of those profits to invest in new products and services to be able to grow. So I can, as a company, give the investor the profits because I got to take some of the profits and reinvest. So the real value of the company is the profit after the reinvestment. Unfortunately, the accountants don't have a term for that. So the finance people created our own term for that, and we call that free cash flow. Free cash flow is the real value of the company because it is the cash that can be distributed to the investors because it represents the profit after the reinvestment. That is the true discretionary cash that the business has to either put back into businesses, to do acquisitions, to pay back investors. Free Cash Flow also represents the theoretical payout rate of a business. It is the cash that is free and clear or unencumbered. If a company does not distribute its free cash flow it can put it in the bank and grow its cash reserves. Otherwise the cash can be used to pay interest, pay off debt, pay dividends or repurchase stock. So it's a critical metric for the investors to understand. On a very technical level free cash flow, is the cash coming from the income statement minus the cash reinvested in the balance sheet. Or, think of it this way. Cash from the income statement minus change in balance sheet equals free cash flow. But what you really need to understand is when you see free cash flow, if it's positive, that means that the company is generating more cash than it reinvests. If it's negative, that means the company is investing more cash than it earns, which means it's going to have to find that cash from somewhere, which means it's probably going to have to borrow money or draw down its savings account. So again, it gives a much better understanding to the investors of what's going to happen to the cash balance of a company over time. A real world example of this occurred in early 2023 with a company called Bed Bath & Beyond. After a series of strategic and operational blunders which were exacerbated by the pandemic revenue from $12b annually in 2017 to an expected $5b annually in 2023. The company had about $150m of cash on hand and over 3.6B in debt. In 2023 Free Cash Flow was expected to be negative ($1b) based on an expected 2023 loss of about ($1b.). With these numbers you can see why investors were very concerned about the company and its ability to continue. Bankruptcy was a real possibility. With $150m of cash and negative 1b of FCF the company would need an additional =$850m to make it through the year. Given the numbers and the other business challenges that could be an issue. In February 2023 the company raised a contingent $1b in high cost financing. It received $225m immediately with the possibility of another 800m to be released if the company met milestones on the turnaround plan. But even the analysts said this was a short term fix and the company ‘s long term viability was still in question. The second metric we want to discuss is called ROIC or Return on Invested Capital. In a different video, I mentioned two companies that sell the same product and make the same profit margins. They both make 8% selling the same products and services. But here's the point. One company makes that profit margin every 267 days, and the other company makes that profit margin every 135 days. Well, if you think about it, I'd rather make eight cents every 135 days than eight cents every 267 days because if I annualize that number, eight cents every 267 days works out to about 11 cents of cash generated per year. Eight cents every 135 days works out to 22 cents of cash generated per year. So for the same amount of investment, a dollar, I make 22 cents, 22%, if I make eight cents every 135 days. For the same investment, I make eight cents every 267 days. It works out to 11 cents per year. I make less cash. And therefore, the company that makes the margin faster will be more valuable. That annualized number, the 11 and the 22 is called ROIC, Return On Invested Capital, and it's a driver of two things, how profitable you are and how often you make the profit. And here's the key. ROIC is a proxy for free cash flow. It's actually very difficult to figure out free cash flow because we have to rearrange statements, and accountants don't give it to us. But ROIC will tell us what the free cash flow will be. And so, therefore, investors like that metric because it's easier, and it actually will tell you how much value you create. Let’s look at an example of 2 discount retailers in the United States: Walmart and Costco. In 2022 Walmart had an after tax operating margin of 3.4% or 3.4 cents and Costco had an after tax margin of 2.6 % or 2.6 cents. Walmart clearly makes more profit when they sell a product. But Walmart makes the 3.5 cents every 100 days and Costco makes 2.6 cents every 47 days. Which is better? In 365 days Walmart averages 12.4 cents of cash or a 12.4% ROIC while Costco will make 20 cents of cash or a 20% ROIC. By selling its products in half the time Costco can complete 2 cycles or spin the crank twice pushing out 2.6 cents twice in the same time that Walmart spins the cycle to make 3.5 cents once. Now the key to ROIC being more valuable is we assume the same level of growth. If you have an ROIC that's higher, you will generate more free cash flow, you will be more valuable. The one tricky part is when the growth rates are different. But the key insight that you really need to have is that ROIC is a proxy for the free cash flow for the business. Let’s say you have two companies that make 15 and 20% ROIC respectively. That means they make 15 cents and 20 cents of profit per dollar of investment per year. The company making 15% is expected to grow at 10% annually and the company making 20% is expected to grow at 2% annually. Start with 15 cents and grow it at 10% every year. That will be a lot more cash over time than a company that starts with 20 cents but only grows that cash by 2% every year. So value is based on the ROIC growth combination. The math is a little trickier but the concept should be straightforward. There are two drivers of ROIC: 1. how much you make, your profit margin, 2. how often you make it, your financial cycle time, which is your efficiency and your productivity. ROIC is a proxy for free cash flow, which is the profit after the reinvestment, and therefore, will be indicative of the value of the business. And that's what the investors are going to measure you on.