At its simplest, free cash flow [FCF] is found from a company’s cash flow statement by subtracting capital expenditures from cash provided by operations. To refine the approach, one also subtracts tax benefits from stock options, thus arriving at what we call true free cash flow [TFCF]: the cash generated by a business and left over for shareholders or reinvestment. This number can’t lie or mislead in the way earnings per share can.
Another FCF measure we use, to supply another view of the cash generating power of a business, is structural free cash flow [SFCF], or what Warren Buffett calls “owner’s earnings.” This is net income after taxes, plus depreciation and amortization, minus capital expenditures. With these two measures, we see in a few ways how much cash a business is potentially providing to shareholders, period.
To next put a multiple on the cash generated, we calculate the firm’s enterprise value: diluted shares outstanding multiplied by share price, minus cash and equivalents, plus long-term debt – all then divided by the FCF number. As with P/E numbers, the lower the multiple, the less expensive the stock; a low multiple does not automatically mean that the shares are a good investment (it could be a business in decline), but a low multiple along with a strongly growing business will usually pique our interest enough to investigate further.
Today’s spotlight stock, Syneron Medical (ELOS) – a leading designer of lasers for cosmetic surgery – is a good case in point.
Syneron Medical’s Free Cash Flow
For the most recent trailing twelve months [TTM] on which we can calculate results (through June 2006), Syneron Medical’s numbers are as follows.
Structural Free Cash Flow [SFCF]: $44.17 million
Year ago TTM SFCF: $29.49 million
True Free Cash Flow [TFCF]: $34.38 million
Year ago TTM TFCF: $23.94 million
Diluted Shares Outstanding: 27.71 million
Cash & Equivalents: $147.42 million
Long-term Debt: $0
Enterprise Value: $492.68 million
Share Price: $23.10
EV/SFCF Ratio: 11.1
EV/TFCF Ratio: 14.3
Look at those multiples. Syneron is priced attractively to both its SFCF and TFCF. While its cash generating power on both measures has grown by more than 40% (49% and 43%) year-over-year, the stock trades at only 11 times and 14 times the results. (For those keeping score, the stock’s P/E multiple is about the same.)
While we don’t believe that a company deserves to trade at a value multiple equal to its growth rates at all times, a discrepancy this large in a company that we expect to grow at least 20% annualized the next three to four years is well worth paying attention to. It’s growth at a very reasonable price.
Why is Syneron fetching such a discount? For one, the aesthetic laser industry is rife with competition, including but not limited to Cutera (CUTR), Palomar (PMTI) and Cynosure (CYNO). Technologies change rapidly, and though Syneron is a leader in sales growth the past three years, there are no guarantees its success can continue. Additionally, the company has needed to increase spending on marketing recently, and though management claims it will pay off, this has affected the bottom line this year.
Despite these issues, Syneron is an interesting growth business, with strong free cash flow leading to a compelling valuation, operating in an industry expected to double in size the next five years. Today, Syneron’s stock combines strong potential upside with a margin of safety thanks to valuation: in other words, a good risk-to-reward ratio, which is one thing we seek in all of our investments.
Jeff Fischer has positions (stocks and options) in Syneron.