Free Cash Flow, Inflation and Growth: Why Cash Keeps Piling Up on Corporate Balance Sheets

by: Philip Mause

Value investors like Warren Buffett and Seth Klarman stress the importance of "free cash flow" in evaluating companies. Unfortunately, it can be be difficult to define this term and even more difficult to apply it to individual companies. Generally, free cash flow is defined as income plus depreciation and amortization minus capex. The difficulty is that capex can be lumpy and can vary enormously from quarter to quarter. Distinctions should also be made between companies spending furiously to enter an entirely new business or market and companies spending merely to maintain their current market position. There are also companies whose long term strategy involves making multiple acquisitions and the cost of these should arguably be included. But XOM does not acquire an XTO every year and it is difficult to come up with a metric for estimating an annual average acquisition budget.

This does not mean that free cash flow is irrelevant or should be disregarded. It is a measure of the cash that an enterprise throws off to its investors. In the long run, it is the best measure of the cash available for dividends and stock repurchases. From a private market point of view, it is an excellent measure of what one should be willing to pay for the entire company, and, from a value investor's point of view, that is the key to evaluating the stock.

On the other hand, the "market" looks to earnings, the E in the P/E ratio, as the key metric. This number is more readily available and becomes the key factor analysts use in evaluating stocks. There certainly is a large correlation between stocks with strong earnings and stocks with strong free cash flow and, thus, earnings should not be completely irrelevant from the point of view of a value die- hard focusing on free cash flow. It would be nice if we could discern some trend or pattern in the free cash flow/earnings ratio because it would tend to tell us whether, from a value investors point of view, the current level of earnings understate or overstate free cash flow.

I do not pretend to have a way of calculating this ratio, but I think I have identified some factors that tend to move it in one direction or another.

First of all, it should be obvious that in a period of low growth, there will be a tendency for capex to be diminished. Companies will have to spend less on new capacity and may have opportunities to add capacity at low costs from competing enterprises that are troubled or are going out of business. At the outset of a period of low growth, depreciation and amortization will not be reduced because depreciation and amortization are a function of past spending and are not affected by the fact that less spending is taking place in the present. Thus, a period of low growth or a business with low growth will likely have a reasonably high free cash flow to income ratio. In this connection, the tobacco companies (MO and PM) seem to consistently have depreciation levels higher than their levels of capex - it is not an accident that they can pay out a relatively high percentage of earnings as dividends.

A less obvious factor is inflation. As a general matter, inflation tends to produce capex in excess of depreciation and amortization because the nominal cost of new capacity is higher than the cost of existing capacity and depreciation is based on the latter. In grossly oversimplified terms, consider a trucking company which maintains a fleet of 5000 trucks, each of which is scrapped at the end of 5 years with no residual value and buys 1000 new trucks each year at a cost of $100,000 per truck. In a world with no inflation, it will have a capex of $100 million and depreciation of $100 million each year. If there is suddenly a period of 10 percent inflation, at the end of the first year capex will be $110 million and depreciation will still be $100 million. Free cash flow will be $10 million less than earnings. After 5 years (with no compounding for simplification), capex will be $150 million and depreciation will be $120 million - free cash flow will be $30 million less than earnings. Inflation has a demonstrable tendency to produce capex in excess of depreciation and to reduce free cash flow as a percentage or earnings. It is interesting that some of the companies that have piled up the most impressive amounts of cash (MSFT, CSCO, INTC) are in the tech sector, where deflation has likely been taking place due to technological progress.

Thus, in a world with low inflation and low growth, free cash flow may be higher in relation to earnings than in a world of high inflation and rapid growth. Of course, low inflation and low growth also tend to produce lower growth in nominal earnings. But - because the market focuses on earnings rather than free cash flow - there may be a tendency of the market to undervalue stocks at a time like this when free cash flow as a percentage of earnings is likely to be relatively high. The opposite is likely to occur when growth resumes and inflation picks up as earnings prospects improve; the market may ignore the fact that inflation and growth are reducing the ratio of free cash flow to earnings.

Disclosure: I am long XOM, PM, MO, MSFT, CSCO, INTC.