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?
It is the ability to generate free cash flow that makes a business worth anything to begin with, and it is the ability of management to allocate that cash flow properly that determines whether the value of the business rises or falls. There are only five things that management can do with a company’s free cash flow: pay a cash dividend, buy back stock, pay down debt, make an acquisition, or invest in internal projects. If a company can invest, either internally or in an acquisition, and generate a marginal return on invested capital (ROIC) that is greater than its marginal cost of capital, then making that investment will increase the value of the business. But if the return is going to be less than the cost of capital, making the investment reduces the value of the business, and management should return the capital to the shareholders instead through one of the three methods listed above. Accrual-based accounting measures such as earnings, and valuation metrics based on earnings, simply do not provide the relevant information as to whether a company is successfully generating free cash flow and whether management is allocating that cash flow properly.
