With the reflation trade gathering pace, long-favoured tech stocks have begun to underperform. Over the past 6 months, the tech-heavy US Large-cap Growth sector is up 14% versus +77% for US Small-cap Value.
This is likely just the beginning. Tech valuations are still incredibly high, and the sector is now lapping difficult earnings comps that were inflated by Covid. To top it off, regulatory pressure is mounting along with global agreements on how to increase taxes for digital businesses.
As tech stocks fall, it won’t be long before brokers and commentators start pushing them as value trades. One of the most likely measures they will focus on is Free Cash Flow (FCF), with metrics like Free Cash Flow Yield or Price to Free Cash Flow. These are classic valuation measures, but here’s why you need to be careful.
Free Cash Flow – What it is and Why it Matters.
Free cash flow is the spare cash a business generates each year. In theory, this can be used to reward shareholders (through dividends or buybacks), to pay off debt, or it can be saved up for future spending.
Traditionally, Free Cash Flow is calculated as: Operating Cash Flow – Tangible Capex.
Free cash flow is central to calculating a company’s intrinsic value. Intrinsic value is often defined as the sum of the company’s future free cash flows discounted back. This is basically adding up all the spare cash that can be paid out to shareholders.
Free cash flow is often preferred to Earnings metrics because it is less prone to accounting manipulations. There have been many instances in the past where companies appeared to be making healthy profits but did not generate any real cash. These have tended to blow up in the end.
The Trouble with Tech...
Free cash flow is a really useful metric for fundamentals-based investors. Identifying stocks with low Price-to-FCF multiples or high Free Cash Flow Yields has long been a favoured tool for bargain hunters.
However, when it comes to tech stocks, free cash flow can be highly misleading. Often stocks can appear far more cash generative than they really are.
The first problem is that most of the capital expenditure undertaken by tech companies is intangible, not tangible. This might include things like software, licences, patents or capitalised research costs. This is real money that tech companies have to spend each year, in the same way manufacturers have to buy machinery or buildings. Intangible capex is central to keeping a business going.
Furthermore, operating cash flow adds back the amortisation of intangibles. It would be totally misleading to add back a non-cash allowance for historic intangible expenditure while not deducting current intangible capex. Sadly, this is exactly what investor platforms like Bloomberg do!
Hence, for tech companies, free cash flow should be calculated as:
Operating Cash Flow - Tangible Capex - Intangible capex
The next problem is share options expenses. Tech companies retain their best and most talented staff by paying them huge amounts of share options. These can amount to billions of dollars. They are part of people’s salaries and a real cost for the business and for shareholders. Issuing all these new shares dilutes the value to existing shareholders, as does buying back shares for the purpose of options issuance. Thus, we need to make another deduction to free cash flow:
Unfortunately, that’s not all. When you operate in a cutting edge industry that constantly faces disruption and change, the only way to stay relevant is to constantly buy up other businesses. These might be competitors, disruptive start-ups or companies with strategically important technology. Facebook is a great example of this. If Facebook wasn’t constantly hoovering up other companies like WhatsApp and Instagram, it would almost certainly be declining by now. Once again, all this M&A (whether it is paid with cash or shares) costs existing shareholders real money.
So now we have:
True Free Cash Flow = Operating Cash Flow - Tangible Capex - Intangible capex - Share options expense - Annualised M&A spend
True Free Cash Flow - A Worked Example: Alphabet (GOOGL)
I am going to use Alphabet (also known as Google) as an example of the difference between theoretical and true free cash flow. Just to be clear, I am making no recommendation as to whether Google is a good investment or not.
For simplicity, I am going to do a one-year cash flow example using the 2020 Annual Report. In practice, it is worth looking back over several years, as cash flows can be lumpy. To get a feel for normalised free cash flows, you may need more than the most recent year.
In 2020, Alphabet generated $65124m of operating cash flow, and spent $22281m on tangible capex.
Thus, Alphabet’s Conventional FCF is $42843m
However, Alphabet also spent $744m on intangible assets and $2.1bn on Fitbit. Note that M&A can be lumpy, but this may provide a pretty good run rate for what is one of the most acquisitive companies in the world.
Then there was $12991m of stock-based expenses from the income statement.
Put all that together and Alphabet’s True Free Cash Flow is:
$65124m operating cash – $22281m tangible capex – $744m intangible capex – $2100m M&A - $12991m employee stock options expense = $27008m
As you can see, even with a highly cash generative mega-corp like Google, the difference between conventional free cash flow and true free cash flow is very large – nearly 40%! What you’ll find is that with most other tech businesses (and especially smaller ones) the gap is even wider. Many turn out to be generating no cash at all!
When to Buy Tech?
Now we have a tool for calculating true free cash flow for tech stocks, when should we snap them up?
Going back to the fundamentals of value investing, the idea is to buy stocks when they are bargains - i.e. trading at way below their true worth.
The discount between the true value and what you pay is your Margin of Safety.
A neat trick with growth stocks is to treat all the future growth as your margin of safety, by pricing them as no-growth businesses.
A useful rule of thumb is that a stock which will exist in perpetuity but with no growth other than inflation should trade on roughly an 8% free cash flow yield (or 12.5x P/FCF if you prefer).
Thus if you can find tech stocks with decent long-term growth prospects and strong balance sheets trading on less than 12.5x P/True Free Cash Flow, you will probably be getting a bargain.
Some people with short memories will say tech will never get that cheap. Well, it always has in the past, and has often been even cheaper. What is especially important this time round is that very few holders of tech stocks today have done fundamental work on intrinsic value. Instead, you’ve got quants, passives and ETFs, and even punters who are just speculating to make a quick buck or pay off some debt. If those hot tech shares start falling, the majority will sell and keep selling for reasons other than fundamental value; just as they bought them for reasons other than value. And so, just as their prices went too high, they will also fall too low.
Free Cash flow is a really useful metric for valuing companies.
However, with many businesses, especially tech, conventional free cash flow can be misleading. It overstates how cash generative the business is, by ignoring key costs such as options expenses, intangibles and M&A. For tech companies, these tend to be very large ongoing expenses.
Thus, it is worth calculating a True Free Cash Flow measure, by deducting spending on intangibles, M&A and share options. This gives a better picture of how much money is being created for shareholders. Normally, true free cash flow will be far lower than conventional free cash flow for tech stocks.
Be patient: tech still looks very dear. When the speculative boom ends, tech could fall a long way as speculators and passive investors dump holdings. A good time to buy is when growing tech stocks with strong balance sheets trade below 12.5x True Free Cash Flow. Happy Hunting!