What drives free cash flows
Wealth Insight|December 2021
...and how to use this understanding to pick winning stocks
SAURABH MUKHERJEA

The valuation of any business is the net present value of all expected free cash flows in future. As a result, for every business, an investor needs to build their expectation of the quantum of growth and the longevity of growth in free cash flows. This is a universal concept that applies to every business. However, what is not common across businesses is the primary driver of free cash flows (which particularly affects the quantum of growth in free cash flows). Consider the following examples.

Type 1 Book value as the primary driver of free cash flows: Let's assume that there is a business which has a unique manufacturing process in a factory. The factory produces a product which meets an essential demand of a large customer base. Furthermore, let's assume that no competitor can produce a substitute product to meet this customer demand. As the business reinvests capital to expand its manufacturing capacity (plant and machinery), it delivers growth in free cash flows. To invest in such a business, investors must focus on growth in its asset base as the primary driver of its moat and hence free cash flows in the long term. Until half a century ago, investment in many great businesses was carried out on this basis (when the P/B multiple was a commonly followed metric).

Type 2 - Profits as the primary driver of free cash flows: Let's say there is a business which has an exceptionally strong brand recall that cannot be replicated by a competitor. Since there is nothing differentiated about its product quality, the business outsources the entire manufacturing process, and hence it is an 'asset-light business. The primary moat of such a business is its ‘brand'. At the simplest level, the more this business advertises its brand across various media channels, the more it delivers volume growth, revenue growth and hence profit growth. Investing in such a business requires focus on only the 'profit and loss' statement - how much of profits from a given year get reinvested in advertising next year. Over the last 40 years, as penetration of mass media increased across countries, there were several such great businesses. It is not worth considering the P/B multiple for such a business - its P/B multiple will keep rising as the business grows (because the business is outsourcing its 'B'). Instead, the P/E multiple is more relevant for such a business.

Here is an interesting comparison of two different businesses from the same industry on P/B multiples Procter & Gamble and Colgate Palmolive (the parents of both are listed in the US). P&G has grown its business through numerous acquisitions. These acquisitions have brought significant goodwill on to its balance sheet. On the other hand, Colgate-Palmolive has a negative accounting book value because its most valuable assets are the brands it has developed in-house over its hundred plus years of existence. Hence, P&G looks cheaper based on the P/B multiple compared to Colgate (because the denominator is much bigger in the case of P&G). The two companies are in the same industry, but given the differences in their capital-allocation approach, one looks significantly cheaper than the other on the P/B multiple and that highlights the irrelevance of P/B.

Let's now move forward another step to see businesses have which evolved even further and thus made the P/E multiple irrelevant. Let's understand this more through a third type of business.

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