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.
China has launched a new policy framework, “Common Prosperity,” which escalates government steerage of the economy and features two critical initiatives. First, Beijing is taking action to tame the country’s real estate obsession. Second, the “summer blizzard” of regulatory actions has targeted a wide range of tech-related sectors including fintech, social media, online tutoring and gaming. Here, we examine the implications for investors of the pendulum swinging ever further in favor of the state.
China’s “Common Prosperity”: What Does it Mean for Investors?
The recent surge in start-ups and unicorns reflects the broadening of the digital revolution across industries, and suggests improving productivity and free cash flow. Further, although the digitization of the economy is still in early earnings, we expect digital platforms to represent the majority of market cap by 2025, with tech, health care and communications the most promising sectors.
The Pandemic Accelerant Part II: Turbo-Charging the Digital Economy
Inflation risks are at a four-decade high due to today’s combination of a generous Treasury, an overly tolerant Fed, and a reopening economy. While our base-case scenario assumes only a brief period of above-target inflation, investors should brace themselves for more inflation scares, which will likely remain a key driver of equity markets well into 2022.
During the past two years, CBDC has progressed from a bold speculative concept to a seeming inevitability and will soon be a core feature of our financial ecosystem. The rollout of CBDCs will further accelerate the digitization of the economy, which is the key defining feature of markets over the past decade. This paper explores the implications for monetary policy, the FinTech and payments sectors, and the potential disintermediation of significant swaths of the commercial banking system.
Money 3.0: Central Bank Digital Currencies (CBDC)
The Cambrian explosion of exciting breakthroughs in AI, autonomous driving, 5G, and cloud computing will drive double-digit growth in semiconductor revenues for the foreseeable future. Superstar firms have come to dominate all subsectors of the increasingly concentrated semiconductor industry, which implies pricing power and explains the sector’s attractive operating margins and return on capital. Valuations are reasonable, and we have a constructive view on the semiconductor sector and believe it possesses considerable upside.
Moore’s Law & the Race for the Rest of the Chessboard
Both sides of the political spectrum have been increasing their calls for regulatory action on the Big Tech companies. Here we explain why tech will continue to be the most dynamic sector of the economy, and why we expect greater breadth in tech market leadership and the emergence of entirely new sub-sectors.
Will Biden Take On the Tech Barons?
More than just our proprietary stock selection model, the Epoch Core Model (ECM) is a rules-based expression of Epoch’s free cash flow investment philosophy. Learn more about the components that make up the ECM and how it’s being used to enhance the firm’s investment processes across strategies, to surface ideas for further research, to prioritize our research queue, and to inform our portfolio construction process.
The Epoch Core Model: Our Proprietary Stock Model
In understanding the performance of any investment strategy, it is important to pay attention to how real economic events drove that performance, rather than fall back on a set of abstract factor returns as if they were somehow responsible.