Free Cash Flow E-Book

George C. Christy

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 261

Veröffentlichungsjahr: 2009

Beschreibung

The purpose of this book is to explain Free Cash Flow and how to use it to increase investor return. The author explains the differences between Free Cash Flow and GAAP earnings and lays out the disadvantages of GAAP EPS as well as the advantages of Free Cash Flow. After taking the reader step-by-step through the author's Free Cash Flow statement, the book illustrates with formulas how each of the four deployments of Free Cash Flow can enhance or diminish shareholder return. The book applies the conceptual building blocks of Free Cash Flow and investor return to an actual company: McDonald's. The reader is taken line-by-line through the author's investor return spreadsheet model: (1) three years of McDonald's historical financial statements are modeled; (2) a one-year projection of McDonald's Free Cash Flow and investor return is modeled. Five other restaurant companies are compared to McDonald's and each other using both Free Cash Flow and GAAP metrics.

Leseprobe

Table of Contents

Also by George C. Christy

Title Page

Copyright Page

Dedication

Foreword

Preface

WHAT MAKES THIS BOOK UNIQUE

WHAT EACH CHAPTER DOES

WHO THE BOOK IS FOR

WHAT THE BOOK IS NOT

A DIFFERENT PERSPECTIVE

CHAPTER 1 - Investing 101

PRICE

FREE CASH FLOW

RISK AND RETURN

THE RETURN MULTIPLE

RETURN AND PRICE

DEBT

EQUITY

DEBT VERSUS EQUITY

PRIVATE COMPANY VERSUS PUBLIC COMPANY

CHAPTER 2 - The Accounting Fog Machine

GAAP: COMPETING THEORIES, MATTERS OF OPINION, POLITICAL COMPROMISES

GAAP: ACCRUAL ABUSE

GAAP: ERRORS BRED BY COMPLEXITY

GAAP’S GAP

GAAP EPS: AN INCOMPLETE DEFINITION OF FINANCIAL PERFORMANCE

GAAP EPS: INVESTING IN AN ECONOMIC VACUUM

EBITDA IS NOT A CASH FLOW METRIC

THE GAAP CASH FLOW STATEMENT

BEWARE THE BALANCE SHEET

LIQUIDITY

FIXED ASSETS AND DEPRECIATION

LEVERAGE AND DEBT SERVICE

WHOSE RETURN ON EQUITY?

THE NOTES

WHEN DO ACCRUALS MEET CASH FLOWS?

WHAT IS TO BE DONE?

CHAPTER 3 - Free Cash Flow

RECONCILIATION OF NET INCOME AND FREE CASH FLOW

FREE CASH FLOW VERSUS NET INCOME

A UNIVERSAL DEFINITION?

ACADEMIC RESEARCH AND THE DISCOUNTED CASH FLOW MODEL

BARRON’S RANKINGS

BUY-SIDE USERS

PRIVATE EQUITY FIRMS

WARREN WHO?

A VAST MEDIA CONSPIRACY?

FASB STAFF FINDINGS

FAS 95: A CRUEL RULE

EPS MISSES: THE REAL DEAL

AN ALTERNATIVE TO THE GOVERNMENT NUMBER

CHAPTER 4 - The Free Cash Flow Statement

BUILDING THE FREE CASH FLOW STATEMENT

FOUR KEY QUESTIONS

REVENUES

OPERATING CASH FLOW

Δ WORKING CAPITAL

CAPEX

CAPEX: MAGNITUDE AND RISK

CAPEX AND CAPITAL

CAPEX TRANSFER

CAPEX VISIBILITY

CAPEX AND INVESTOR RETURN

FREE CASH FLOW

FREE CASH FLOW YIELD

CHAPTER 5 - Free Cash Flow Deployment

ACQUISITIONS

BUYBACKS

DIVIDENDS

DEBT

PROJECTING INVESTOR RETURN

CHAPTER 6 - The Free Cash Flow Worksheet

WORKSHEET FEATURES

ENTERING HISTORICAL DATA

ADJUSTMENTS TO GAAP CASH FLOW

OPERATING CASH FLOW

CAPEX

FROM THE BALANCE SHEET

THE FREE CASH FLOW STATEMENT

GAAP DATA

PERCENTAGES

PER SHARE DATA

INCREMENTAL DATA AND COMPANY’S REINVESTMENT RETURN

CASH SOURCES AND DEPLOYMENTS

ACQUISITIONS

BUYBACKS

DIVIDENDS

DEBT

OPERATIONS

PROJECTING FREE CASH FLOW

PROJECTING CASH SOURCES

PROJECTING ACQUISITIONS

PROJECTING Δ IN SHARE VALUE DUE TO Δ IN THE NUMBER OF SHARES

PROJECTING INVESTOR RETURN FROM DIVIDENDS

PROJECTING Δ IN SHARE VALUE DUE TO Δ IN DEBT

PROJECTING Δ IN SHARE VALUE FROM OPERATIONS

GAAP DATA, PERCENTAGES, AND PER SHARE DATA

INCREMENTAL DATA AND COMPANY’S REINVESTMENT RETURN

INVESTOR RETURN PROJECTION

RETURN MULTIPLE

ADDING PERIODS TO THE WORKSHEET

USING THE WORKSHEET

CHAPTER 7 - Six Companies

REVENUES

PERCENTAGE CHANGE IN REVENUES

OPERATING CASH FLOW MARGIN

CAPEX AS A PERCENTAGE OF REVENUES

FREE CASH FLOW MARGIN

FREE CASH FLOW PER SHARE

THE GOVERNMENT NUMBER

NET NONWORKING CAPITAL ITEMS

MCDONALD’S

PANERA BREAD

APPLEBEE’S

P. F. CHANG’S BISTRO

CHEESECAKE FACTORY

IHOP

THREE MUSKETEERS WITHOUT NEW UNIT CAPEX

WHOSE RETURN ON EQUITY?

SELL-SIDE ANALYSTS

TOTAL RETURNS

TAKE YOUR PICK

CHAPTER 8 - The CEO and Investor Return

THE CEO’S LETTER TO SHAREHOLDERS

THE QUARTERLY EARNINGS CONFERENCE CALL

THE CEO’S INCENTIVE COMPENSATION

CHAPTER 9 - Finding Great Stocks

THE NINE STEPS

DIVERSIFICATION FOR INDIVIDUAL INVESTORS

EQUITY MUTUAL FUNDS

FREE CASH FLOW AND BONDS

FREE CASH FLOW AND THE FINANCIAL CRISIS OF 2008

APPENDIX A - Equations

APPENDIX B - McDonald’s Income Statement

APPENDIX C - McDonald’s Balance Sheet

APPENDIX D - McDonald’s ROIIC and Weighting

APPENDIX E - McDonald’s ROIIC Calculations

APPENDIX F - Recommended Reading

Notes

Acknowledgements

About the Author

About the Web Site

Index

Also by George C. Christy

Free Cash Flow: A Two-Hour Primer for Management and the Board

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more.

For a list of available titles, visit our Web site at www.WileyFinance.com.

Copyright © 2009 by George C. Christy. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or, except for the Free Cash Flow Worksheet, authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. The Free Cash Flow Worksheet in whole or in part may not be reproduced, stored in a retrieval system, or transmitted in any from or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the Publisher. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:

Christy, George C. Free cash flow: seeing through the accounting fog machine to find great stocks/ George C. Christy. p. cm. - (Wiley finance series) Includes bibliographical references and index.

eISBN : 978-0-470-48498-2

For my mother, Kathleen Stinchfield ChristyFor my wife, Nobuko Miyachi ChristyFor our son, AndrewFor our daughter, Anna and her husband, Evan

Foreword

In our recent book, Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor (John Wiley & Sons, 2007), we offered a comprehensive introduction to the opportunities and challenges inherent in today’s equity markets. By looking beyond the many obfuscations of traditional generally accepted accounting principles (GAAP) accounting, we endeavored to provide the informed investor with the tools necessary to navigate a changing investment landscape.

In George Christy’s new book, Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks, the author brings these concepts to a new and eminently actionable level. In addition to providing practical definitions of difficult financial concepts, he teaches the investor/reader how to reengineer the accountant’s obtuse financial statements into relevant snapshots of a company’s capital productivity and free cash flow allocation.

The importance of understanding these concepts—free cash flow, in particular—cannot be overstated. For us, and for George Christy, free cash flow can be defined as the cash available for distribution to shareholders after all planned capital expenditures and all cash taxes. Within this definition, virtually all corporate strategies fall into one of five possible uses of free cash flow: cash dividends, share repurchases, debt paydowns, internal capital projects, and acquisitions. Knowing which strategy, or combination of strategies, to select is the key to increasing shareholder value. In this regard, Christy’s insight is invaluable. He provides the reader with a clear, incisive, step-by-step methodology through which a company’s historical stewardship of shareholder capital can be evaluated and its future commitment to responsible free cash flow deployment can be gauged.

The concept of free cash flow has always been important, but never more so than today. This is due to the changing orders of significance within the three sources of shareholder return. The following two exhibits show almost 80 years of decade-by-decade returns for the S&P 500.

The black line in these exhibits displays the rolling 10-year compound annual growth rate for the S&P 500 since 1936. If we disaggregate these returns into their three components—earnings per share (EPS) growth, dividend reinvestment, and changes to the price-earnings (P/E) ratio—we can see how the relative importance of each of these three drivers shifts throughout time. The 1980s and 1990s, for example, were characterized by the expansion of the P/E ratio or, conversely, by falling capitalization rates as applied to equities. Specifically, P/E ratios nearly quadrupled, providing almost half the equity return for the 20-year period between 1980 and 2000. This occurred because interest rates dropped from a high of more than 13 percent in the early 1980s to less than 4 percent by 2000, resulting in lower costs of capital.

Components of Compound Annual Total Returns for Trailling 10-Year Periods (S&P 500 Indes 1926-2007)

Sources : Epoch Investment Partners, Inc., Standard & Poor’s.

Components of Total Return by Decade (S&P 500 Index 1927-2007)

Sources: Epoch Investment Partners, Inc.; Standard & Poor’s.

Earnings and dividends mattered during this 20-year period, but they were of secondary importance. Today, the opposite is true. Going forward, P/E multiple expansion is unlikely to work in the investor’s favor unless interest rates start trending downward. Therefore, it is safe to say that dividends and earnings are likely to account for nearly all of the returns in common stocks in the foreseeable future. And these two drivers come from one place: free cash flow. Never has free cash flow, and the investor’s ability to recognize its efficient allocation, mattered more than it does right now.

It is under this crucial new investment rubric that George Christy has entered the scene. And, in our view, his timing—and his insights—could hardly be better. This book provides the reader with the concepts, the context, and the tools necessary to invest successfully in a global market that has become increasingly challenging for all investors, both institutional and individual. We applaud the author’s efforts and recommend this book to all investors seeking shareholder value creation.

WILLIAM W. PRIEST LINDSAY MCCLELLAND

Preface

For many decades GAAP earnings per share was the financial metric of choice of virtually all professional equity investors. Over the last decade, however, increasing problems with accrual accounting and a growing appreciation of investment economics have caused many professional investors to replace GAAP earnings with Free Cash Flow as their primary financial metric. Free Cash Flow is mentioned by buy-side investors and sell-side analysts in each issue of Barron’s and on a daily basis on CNBC’s market programs. Yet in spite of the rapidly growing popularity of Free Cash Flow, investors have not had recourse to a book that not only explains Free Cash Flow in detail but also shows how to use Free Cash Flow to increase investor return. This book does both. It also offers the reader a preformatted Excel worksheet that integrates the primary components of share value into an investor return model.

WHAT MAKES THIS BOOK UNIQUE

This book is not a long list of tips about investing. The book shows the investor how to use two new investment tools to find great stocks and increase investor return. The Free Cash Flow Statement© and the Free Cash Flow Worksheet© were created and developed by the author for this book. The Free Cash Flow Statement enables the investor to focus on the primary drivers of investor return: revenues, cash operating margin, and use of capital. The Free Cash Flow Worksheet is a preformatted Excel spreadsheet in which investors can do their own Free Cash Flow and investor return projections. In doing so, the Free Cash Flow Worksheet provides investors with an understandable, practical alternative to the discounted cash flow model used by many professional investors.

WHAT EACH CHAPTER DOES

Because this book is aimed at the widest possible audience, Chapter 1 begins with an explanation of some basic finance principles. It uses examples that anyone familiar with an income statement and a balance sheet can easily understand. Chapter 2 explains how GAAP accounting makes it difficult for investors to understand public companies’ financial performance. Chapter 3 reconciles Free Cash Flow with GAAP earnings and describes the advantages of Free Cash Flow. Chapter 4 takes the reader step by step through the Free Cash Flow Statement. Chapter 5 explains how Free Cash Flow deployment can enhance or diminish investor return. Chapter 6 uses McDonald’s 2004- 2006 financials to lead the investor, row by row, through the Free Cash Flow Worksheet. After entering three years of selected data from McDonald’s historical financial statements, we do a one-year projection of McDonald’s Free Cash Flow and investor return. In Chapter 7, five other restaurant companies are compared to McDonald’s and one another using both Free Cash Flow and GAAP metrics.

Chapter 8 shows the reader how to assess the CEO’s commitment to investor return by analyzing three key information sources: the CEO annual letter to shareholders, the quarterly earnings conference call, and the CEO’s incentive compensation package as described in the proxy. Chapter 9 provides guidance for the investor’s initial foray into Free Cash Flow investing. Some of the topics addressed include finding stock candidates, screening, using the worksheet, and the CEO Exam.

WHO THE BOOK IS FOR

The book is for experienced investors. It is assumed the reader already follows an established due diligence process. The reader is expected to merge the book’s Free Cash Flow and investor return analytics with the reader’s existing due diligence discipline. Investors who read the book without using the Free Cash Flow Worksheet will no doubt enhance their understanding of Free Cash Flow and investor return. But by working with the Free Cash Flow Worksheet with, say, just 5 or 10 companies, the reader will develop a much deeper understanding of the benefits and limitations of Free Cash Flow investing. There is no guidance in the book on using Excel. Readers without Excel experience are on their own.

In addition to investors, the book’s intended readers include:

• Clients of investment management firms

• Training programs of investment management firms

• CEOs, CFOs, and board members of public companies

• CEO and CFO candidates

• Corporate managers, division heads, vice presidents

• Management training programs

• Business schools

WHAT THE BOOK IS NOT

The book is definitely not appropriate as an introduction to equity investing. It does not cover all aspects of equity investing. Its focus is narrow but intense: analyzing a company’s financial performance from the equity investor’s vantage point. The Free Cash Flow Worksheet is not appropriate for use on financial companies such as banks, brokerage firms, insurance companies, or REITs. Financial companies’ capital structures and specialized accounting require a specialized approach, just as a specialized approach is required for a GAAP analysis of financial companies.

A DIFFERENT PERSPECTIVE

The vast majority of “how-to-invest” books are written by professional investors. These authors have spent their careers looking at public companies from the outside. Their access to public companies is limited to the companies’ public disclosures and other publicly available information. Their books consist primarily of investing tips often in the form of do’s and don’ts. Those authors also talk at length about their biggest stock winners (and sometimes losers). By carefully picking and choosing from these menus of tips and tales, investors hope to enhance their stock-picking skills and improve their equity returns.

This book is not written by a professional investor. The author was most recently the treasurer of a public company. For over 30 years before that, he was a corporate banker in Chicago, Tokyo, and Los Angeles. In the course of his banking career, he worked with hundreds of CEOs, CFOs, and board members. To a certain extent, the author’s perspective is skewed by his banking experience, which included numerous contests with CEOs and CFOs over the division of limited cash flows between lender and borrower. Because bank loans are repaid by cash flow, not by GAAP earnings, the author learned early in his career how to analyze cash flow. After his banking years, the author was a consultant at one of the country’s largest investor relations firms. He wrote clients’ quarterly earnings press releases, annual reports and corporate profiles. He also helped client CEOs and CFOs prepare for quarterly earnings conference calls and presentations to investor conferences and meetings.

Throughout his career, the author has been an insider, privy to financial and other confidential information about the companies he has worked with as a banker, consultant, or Treasurer. Furthermore, the author’s career gave him an insider’s appreciation of how CEOs and CFOs manage their companies, their public disclosures, and their relationships with the Street.

The author does not claim to offer an approach to equity investing that is either superior to those articulated elsewhere or will, if replicated by the reader, result in unlimited wealth and fortune. The author does offer an insider’s perspective on cash flow investing that is different from that of the typical equity money manager. Different is not always better, but those investors looking for great stocks should gain new insights and understanding of how to see through the accounting fog machine with Free Cash Flow.

All calculations and statements in this book exclude the return impact of commissions, taxes, and other direct and indirect transaction costs.

The abstract paintings of Jackson Pollock created a lot of controversy in the art world of the 1950s. Pollock’s paintings appeared to some observers to be the result of someone hurling paint cans of randomly chosen colors at a large canvas. One afternoon at a Manhattan gallery’s exhibition of his paintings, Pollock wandered alone through the gallery’s rooms. He encountered a slightly inebriated street person, seeking refuge from a thunderstorm, standing in front of one of Pollock’s colorful works.

The street person looked at Pollock and exclaimed, “This is ridiculous! Any idiot could have done this!”

Pollock glanced at his painting and then turned to the street person and said, “You’re absolutely right. Anyone could have done this, but no one ever did.”

CHAPTER 1

Investing 101

You and I are 50/50 partners in a private equity firm. A friend of ours owns a small manufacturing company that makes outdoor furniture. He wants to retire and has asked us if we would be interested in buying his company. Annual sales are $75 million and he has about 150 employees. He has developed a good management team that will remain after the company is sold. While the U.S. furniture manufacturing industry has been hard hit by low-cost imports, our friend’s business appears to be doing very well. After a tour of the plant and product showroom, we decide it is a good idea to spend some time on an analysis of the company’s business and its financial statements. Our due diligence analysis is focused on one question: What is the likely return we’ll receive on our investment if we buy the outdoor furniture company?

Our investment return from the outdoor furniture company equals the sum of:

1. The difference between the price we pay for the company and the price we receive when we sell it, divided by the price we paid; plus

2. Whatever cash we remove from the company

The cash we take out of the company would be dividends we decide to pay to our firm.

PRICE

The price, both when we buy the company and when we sell it, is primarily determined by two things:

1. The amount of future cash flow the buyer expects the company to generate after the sale closes and

2. The general level of interest rates at the time of the transaction

While we must analyze the company’s historical cash flows to understand the company’s business, when we buy a company we are not buying its historical cash flows. We are buying our right to the company’s future cash flows. The outdoor furniture company’s future cash flows can be divided into two time periods. The first time period is while we own the company. The company’s cash flows while we own it will determine how much cash, if any, we can remove from the company to reinvest or spend as we see fit. The second time period is after we sell the company. Our buyer will estimate the company’s future cash flows and will agree to pay us a price that enables the buyer to obtain the total return the buyer needs in the years after buying the company. Cash flow, unfortunately, is a term that means different things to different people. We will define Free Cash Flow in the next section. The general level of interest rates affects prices of investments. The higher the expected inflation rate during our investment term, the lower the price we should pay for an investment’s future cash flows because there will be fewer goods and services we will be able to purchase with the proceeds (dividends plus the net sale proceeds) of our investment. The lower the anticipated inflation rate, the higher the price we can afford to pay without a decline in the future purchasing power of our investment proceeds.

FREE CASH FLOW

When we purchase 100 percent of a company, we are acquiring the right to all of the company’s future surplus or Free Cash Flow. By surplus and free we mean whatever cash remains after the company:

1. Uses cash to pay its operating costs such as employee salaries, wages and benefits, suppliers, utility bills, legal and accounting fees, taxes, interest on debt if any, and so forth

2. Uses cash to extend credit terms to customers and to build inventory, and

3. Uses cash to buy equipment, computers, vehicles, land, and buildings

Once the company has taken care of its obligations in items 1, 2, and 3, the owners—that would be us if we buy the company—can pretty much do what we want with the Free Cash Flow because it is our company. It is not management’s company. Management has little or no equity at risk. Management is compensated by salary and bonuses while we depend entirely on our investment return for our compensation. We can tell management to use the company’s Free Cash Flow to pay dividends to our firm, to buy other companies if we decide that is a smart thing to do, to repay debt if there is any or to buy back the company’s stock.

Now that we have introduced Free Cash Flow, we can refine our definition of investment return by replacing cash flow with Free Cash Flow. Our investment return, then, is (1) the difference between the purchase price and the sale price (both of which are determined by expected Free Cash Flow), divided by the purchase price and (2) the amount of the company’s Free Cash Flow we decide to pay as dividends to ourselves. Each cash dollar the company spends on its operating costs, customer receivables, inventory, new equipment, new buildings, and other purchases is one less dollar of Free Cash Flow. And one dollar less of Free Cash Flow means less return for us, the owners, because investing is a cash business. We invest cash to buy the furniture company. We expect to receive a cash return on our investment. A Net Income return does not help us because our bank does not accept Net Income deposits. Now that we have defined Free Cash Flow, we can get started on determining the price we are willing to pay for the company.

RISK AND RETURN

We use the yields on U.S. Treasury securities to help us set a ballpark purchase price for the outdoor furniture company. A risk assessment of Treasuries is elementary. If the U.S. Treasury cannot return our principal and interest in full and on time, then our money probably is not worth anything anyway. Say we are thinking of owning and running the furniture company for about 10 years. The company generates $10 million of annual Free Cash Flow and is expected to do as well or better over the next few years. We are confident we can cut some costs and reduce capital utilization. To be conservative, we will ignore any such improvements as well as any sales growth potential in our analysis. Assume the 10-year Treasuries are currently yielding 5 percent. Ignoring the effect of interest reinvestment, that is 5 percent of virtually risk-free Free Cash Flow each year for 10 years followed by the return at maturity of 100 percent of our investment. Given all of the risks involved in owning our new company, it is obvious that our anticipated return on our investment in the outdoor furniture company must be substantially higher than the 10-year Treasuries’ 5 percent yield. What if the company were overwhelmed by new competitors and vaporized in three years? We would be left with nothing but the furniture on our patio.

THE RETURN MULTIPLE

We need to decide how much riskier we think our investment in the furniture company is likely to be compared to an investment of the same amount and maturity in U.S. Treasuries. Do we think the purchase of the company is two times, four times, or 10 times riskier than buying Treasuries? Let’s say we think ownership of the outdoor furniture company would be at least four times riskier than owning Treasuries. A 4x Return Multiple means we should be getting four times the Treasuries’ annual 5 percent return, or an annual return of about 20 percent from owning the outdoor furniture company. Many investors expect around a 15 percent return on public company stocks. Our friend’s company is a small private company, so its shares are much less liquid than the shares of a public company. That additional risk suggests a 20 percent return target is not way out of line. As we learn more about the company in our due diligence, we can adjust our Return Multiple up or down if we learn the company’s business offers more or less risk than our original estimate.

RETURN AND PRICE

We now know our required return on investment is roughly 20 percent. What price should we pay to generate a 20 percent annual return on our investment in the furniture company? Let’s start with the formula for the simple annual yield, or return, of any investment:

(1.1)

The price we pay for the company is the investment in the formula above. To calculate the investment, we divide $10 million of Free Cash Flow by our required 20 percent return and get an investment, or price, of $50 million:

(1.2)

To keep things as simple as possible, we are not incorporating the time value of money in our calculations. Our investment return formula incorporates:

1. The expected Free Cash Flows generated by the investment

2. The price we are paying for the investment

3. The market’s perception of future risk-free interest rate levels for 10 years

4. The relative risk of the investment (the risk relative to 10-year Treasuries)

Our 4x Return Multiple incorporates items (3) and (4). Our assessment of an investment’s ability to generate Free Cash Flow is our critical starting point because we are investing cash and we want to receive our return in cash. Equally critical is the price we pay for the investment. If we overpay for a company, even for a company with outstanding Free Cash Flow prospects, we may not get our expected return. If we pay $60 million for the company, our return will be 18.75 percent, not 20 percent. Or, in other words, a $60 million price would give us a 20 percent return on the first $50 million. What would our return be on the last $10 million? It would be a zero percent return.

By applying our required 4x Return Multiple to the current Treasuries’ yield for the appropriate term, we are reflecting the market’s expectation of the inflation rate during the term of our investment. Again, the higher the expected inflation rate during our investment term, the lower the price we should pay for the Free Cash Flow we are buying because there will be fewer goods and services we will be able to purchase with the proceeds (dividends plus net sale proceeds) of our investment. The lower the anticipated inflation rate, the higher the price we can afford to pay without a decline in the future purchasing power of our investment proceeds. By comparing our investment’s risk to Treasuries in the Return Multiple, we are attempting to ensure we are sufficiently rewarded for the incremental risk we are taking in our equity investment as compared to our investment in Treasuries. We are taking a lot more risk when we buy stocks and we must receive a lot more return. Comparing our expected return on our acquisition opportunity to a Treasuries’ yield may at first seem strange. Our entire analysis is cash-based. We are investing cash and we expect to receive a cash return. We measure our investment’s value by its Free Cash Flow generation and so we must use a cash benchmark return.

The Return Multiple provides yet another benefit. It helps us manage the chances of paying too much for stocks. This is especially important at the peak of strong equity markets when many investors are overpaying for stocks. In that type of market climate, dependence on comparative Price-to-Earnings ratios (PEs)—almost all of which are too high—leads to rude disappointments. Like all financial metrics, the Return Multiple is by no means foolproof. In periods of financial market turbulence, the utility of interest rates as a proxy for future inflation is sometimes diminished. But the Return Multiple does help us take a step back, assess a company’s expected Free Cash Flows in the context of the relative risk and return of alternative investments, and ask: Does this investment really make sense? Well, we offered our friend $50 million for the furniture company and he accepted. Now that we are the owners, we have some decisions to make, but first we need to understand what other financial variables affect our return on investment.

DEBT