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.
Of late, people are blaming a variety of economic ills on an unlikely villain: the desire of investors to earn good returns on capital. But, no industry can be expected to survive if it is not creating value for the investors in that industry. Earning good returns on capital is not an obstacle to satisfying consumer demands; it’s what enables companies to continue to satisfy those demands.
This Is Why We Can’t Have Nice Things
Until recently, we had been living in a disinflationary environment that started in the 1980s. We believe three factors – Deglobalization, Demographics and Decarbonization – have led us to a secular reflationary environment. As a result the next decade is going to look quite different than the 2010s, with a number of critical implications for investors.
The transition to net-zero emissions (NZE) involves a fundamental change in the structure of the economy, and will likely be messy, implying periodic supply shortages and even more volatile energy prices. Further, inflation and nominal interest rates will probably be higher and more volatile, especially relative to the levels of the last two decades. This has not yet been priced into markets.
Greenflation: The Energy Transition Will Prove Inflationary
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.