Philosophy
Epoch believes that the key to understanding a company requires a focus on the cash generation drivers of the business—not a focus on accounting terms like earnings or book value. How does the business generate its free cash flow, and how does management allocate that cash for the betterment of the owners of the business; i.e., the shareholders?
Epoch manages a variety of investment strategies, with different investment objectives. But they all share a common investment philosophy, centered on two key principles:
- The ability of a company to generate free cash flow makes the business worth something.
- How management allocates a firm’s free cash flow determines whether the value of the business rises or falls.
In keeping with a long line of investment theory1, we believe the value of any business is simply the present value of the future free cash flow that the business will produce – i.e., the cash flow that is available to be distributed to the owners. To determine that value, an investor needs to forecast a firm’s growth rate from year to year, as well as how its cost of capital will change over time (since that cost of capital serves as the discount rate in calculating present value). Under a couple of simplifying assumptions – namely, that both variables will be constant – this calculation reduces to a very concise equation:
V = CF1/(r-g)
Where V is the value of the business, CF1 is the cash flow that the business throws off to the owners in year 1, r is the firm’s cost of capital, and g is the growth rate of future cash flow.
A higher level of CF1 in the numerator leads to a higher value for the business. And so does a higher level of g in the denominator (since it makes the denominator smaller). But these two variables are not independent of each other. There is always a tradeoff between growth (which requires reinvestment) and the amount of free cash flow that is left to distribute to shareholders (more reinvestment means less free cash flow, and vice versa). We can see management’s dilemma more clearly if we rewrite the discounted cash flow equation in terms of return instead of price, like this:
r = CF1/V + g
The choice that management always faces in seeking to maximize the return to shareholders is how much of the firm’s cash flow to distribute today as free cash flow yield (CF1/V) and how much to reinvest in the business to create future growth (g).
A company’s return on invested capital (ROIC) plays a key role in determining how management should decide this question. A company’s growth rate is simply the product of how much of its profit it reinvests (i.e., the investment rate) and the ROIC that the company earns on that investment. And of course, the investment rate also determines how much of a firm’s total cash flow remains as free cash flow.
If the prospective ROIC on reinvestment is greater than the cost of capital (the “required return” in the discounted cash flow formula above, which for equity is ultimately an opportunity cost representing what investors could earn elsewhere), management should reinvest. Doing so will create additional value for shareholders. If the prospective ROIC on a proposed investment is less than the cost of capital, reinvesting would destroy value (relative to the return that investors demand), and management should pay the cash flow out to owners, so they can invest it elsewhere and earn a higher return.
Regardless of the strategy they support, all of Epoch’s analysts and portfolio managers evaluate companies using this framework focused on free cash flow generation and capital allocation practices.
1 See, for example, The Theory of Investment Value, John Burr Williams, 1938; Gordon, Myron J. (1959), “Dividends, Earnings and Stock Prices”. Review of Economics and Statistics. The MIT Press. 41 (2): 99–105.
Our Perspectives
There have been two monumental crises in the past two decades, the Global Financial Crisis and the current COVID-19 pandemic. While the COVID-19 crisis is crippling financial markets in a similar fashion, monetary policy in the form of QE will not be the silver bullet we need. The solution to the current crisis will require prudent fiscal policy to see us through.
March 16, 2020
Comparing Two Market Crises: A New Type of Crisis Requires a New Solution
There have been two monumental crises in the past two decades, the Global Financial Crisis and the current COVID-19 pandemic. While the COVID-19 crisis is crippling financial markets in a similar fashion, monetary policy in the form of QE will not be the silver bullet we need. The solution to the current crisis will require prudent fiscal policy to see us through.
The dispute between the U.S. and China is clearly not just about trade, or even technology. At stake are the values that will determine the architecture and governance of the global world order.
December 2, 2019
Cold War 2.0: The Platform, the Players, and the Stakes
The dispute between the U.S. and China is clearly not just about trade, or even technology. At stake are the values that will determine the architecture and governance of the global world order.
The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fueled a surge in IPO listings and produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals. The big question is, are we repeating the excesses of the dot-com boom? In this paper, we look at the reasoning used by those who think history is repeating itself including IPO supply, profitability and VC funding. We also look at the weaknesses in those arguments and why some believe that the current situation is different from the dot com bubble, such as median age of tech IPOs and sales growth. Finally, we explore how investors can look at these companies through a free cash flow lens.
June 19, 2019
Blitzscale and Hope: Unicorns, IPOs and the Fear of Repeating the Late 1990s
The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fueled a surge in IPO listings and produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals. The big question is, are we repeating the excesses of the dot-com boom? In this paper, we look at the reasoning used by those who think history is repeating itself including IPO supply, profitability and VC funding. We also look at the weaknesses in those arguments and why some believe that the current situation is different from the dot com bubble, such as median age of tech IPOs and sales growth. Finally, we explore how investors can look at these companies through a free cash flow lens.
Does a stock’s price and its P/E ratio tell you how much a company is worth? Conventional wisdom says yes, but we think otherwise. In this paper we explore:
- The theory behind the discounted cash flow (DCF) valuation model and the underappreciated role that ROIC plays in the model
- The P/E ratio and find that it does not tell us what most people think it does, nor does its offshoot, the P/E to growth (PEG) ratio
- How we can use what we have learned about the DCF model to deconstruct P/E ratios in the real world to better understand what they do tell us
June 17, 2019
The P/E Ratio: A User’s Manual
Does a stock’s price and its P/E ratio tell you how much a company is worth? Conventional wisdom says yes, but we think otherwise. In this paper we explore:
- The theory behind the discounted cash flow (DCF) valuation model and the underappreciated role that ROIC plays in the model
- The P/E ratio and find that it does not tell us what most people think it does, nor does its offshoot, the P/E to growth (PEG) ratio
- How we can use what we have learned about the DCF model to deconstruct P/E ratios in the real world to better understand what they do tell us
If there is a “small-cap effect” then why has the Russell 2000 underperformed the Russell 1000 over time?
January 18, 2019
The Size Paradox
If there is a “small-cap effect” then why has the Russell 2000 underperformed the Russell 1000 over time?
China’s mercantilist behavior, underscored by its “Made in China 2025 initiative,” is in conflict with U.S. demands for greater IP protection, a level playing field and improved market access. Left unresolved, free trade and globalization will be in retreat, with broad economic implications beginning with manufacturers.
December 10, 2018
Trump, Tech and Trade
China’s mercantilist behavior, underscored by its “Made in China 2025 initiative,” is in conflict with U.S. demands for greater IP protection, a level playing field and improved market access. Left unresolved, free trade and globalization will be in retreat, with broad economic implications beginning with manufacturers.
Three developments (the unwinding of QE, the soaring US budget deficit and the impending wall of maturities, especially of corporate bonds) will engender higher volatility and wider credit spreads. There is also a risk that interest rates will start rising for “bad” reasons (that is, an increase in fixed income supply). Each of these outcomes would be a headwind for high duration strategies.
July 2, 2018
The Return of Price Discovery
Three developments (the unwinding of QE, the soaring US budget deficit and the impending wall of maturities, especially of corporate bonds) will engender higher volatility and wider credit spreads. There is also a risk that interest rates will start rising for “bad” reasons (that is, an increase in fixed income supply). Each of these outcomes would be a headwind for high duration strategies.
Modern Portfolio Theory (MPT) dominates investment thinking today, but the pre-MPT view of the world still holds valuable insights. Our new white paper explores the limits of MPT in aiding successful investing.
April 13, 2018
The Limits of Theory
Modern Portfolio Theory (MPT) dominates investment thinking today, but the pre-MPT view of the world still holds valuable insights. Our new white paper explores the limits of MPT in aiding successful investing.