The Unforgivable Sin: Buying stocks in a company without positive free cash flow
As a fig tree is planted to produce fig fruits to the sower even so a company is created to generate cash for its shareholders. If Christ cursed the fig tree (Mark 11:12-25) because it failed to reciprocate, the Christian investor should avoid companies which failed to generate cash after they have been supplied with capital from shareholders.
It would be foolhardy of the sower to continue caring for a fig tree which refuses to produce fig fruits. Yet, in 1998, 1999, and 2000 investors continued the unforgivable sin of purchasing shares in Enron, a company which transgressed the laws of reciprocity, which at best produced a NEGATIVE FREE CASH FLOW. What paternal wisdom provided the philosophy to purchase Enron shares? What tempter temped investors to such an unsavory conclusion?
Perhaps investors purchased Enron shares without reading its annual reports. “The simple believe anything, but the prudent give thought to their steps” – Proverbs 14:15. If investors had just spent an afternoon diversion looking at Enron’s reports and doing some elementary arithmetic they would have discovered that Enron was generating a negative free cash flow – it consumed more cash than it produced.
Never buy stocks (partial ownership) in a company if its free cash flow is negative.
So, what is free cash flow? Free cash flow is cash generated from operations minus capital expenditure (fixed assets). To put it in layman’s term, it is money left to shareholders after all the transactions of the business have been conducted.
Indulge me for a moment. Suppose you own an ice-cream shop. You buy the flavors, the sweets; you pay for the utilities, the rent, and sorts. After selling ice cream and settling your expenditures for a certain period, the money left over is the cash flow from operations (say, for example, $30,000). You may, during that time, come to the conclusion that your business could benefit from an extra truck to deliver ice cream to wholesale customers. And so you purchased a truck (capital expenditure) for $14,000. Your free cash flow (what is left to you, the owner) is $30,000 – $14,000 = $16,000.
Benjamin Graham and David Dodd in their book, Security Analysis, referred to free cash flow as owners earning, “the amount of cash an owner can pocket after paying all expenses and making whatever investment are necessary to maintain the business. This free cash flow is the well from which all returns are drawn, whether they are dividends, stock buybacks or investments capable of enhancing future returns.”
As a side note, Benjamin Graham was Warren Buffet’s mentor.
Free cash flow gives the company flexibility to return cash to shareholders in a variety of ways:
- Free cash flow can be used to issue dividend payments to shareholders. In my opinion, dividends is the cash companies pay investors while they wait for an appreciation in stock price
- Free cash flow allows companies to buy back their stocks, reducing number of shares outstanding, thus improving earnings per share
- Free cash flow is used to finance mergers and acquisition
- Free cash flow enables companies to pay down debt quicker
- Free cash flow can be used to expand the company by allocating capital to projects with good return on investment
- Free cash flow can be viewed as a good insurance policy to inoculate companies from unforeseeable events such as economic downturns
It is important that the Christian investor does a thorough analysis of a company before selecting it as a good candidate for investment. Older, more mature companies have a history and provide a manifold of data for proper analysis. Correspondingly, companies with good free cash flow often are in mature industries because capital requirements for growth are limited and financing demands are modest, so free cash is plentiful.
The quantity of free cash flow generation is also indicative of the quality of management and how efficient it is at allocating capital to project with high returns on invested capital (ROIC). How management deploys cash stands supreme. Free cash flow generation is prima facie evidence of capable management.
Free Cash Flow Checklist
An investor should always have a checklist, a benchmark to determine whether a company meets the grade, is qualified as a good investment based on the investor’s standard. It is prudent to buy stocks when the rate of return on free cash flow is 15% or more. In situations where the company is undergoing a growth spurt, 10% will suffice.
Companies are not static, they are dynamic in all facets, even their fixed cost changes. Therefore, the Christian investor should not rely on one year calculation of free cash flow, he/she should depend on an average free cash flow for at least a 3 to 5 year period, so as to not be misled by gyrations, abnormal performances, and cyclical downdrafts.