Follow the Money

A Framework for Investors to Evaluate Management as Capital Allocators

Philip W. McCauley, III, CFA, and Brett C. Neubert, CFA

The authors would like to acknowledge Sandra L. Ballard, without whose research, analysis, and technical skills this paper would not have been possible.

Introduction

Free cash flow is an important valuation tool in the investment community and the preferred metric of many value investors. A common assertion among this group is that publicly traded shares represent ownership of a slice of a business and so intrinsic value of a stock can be derived by valuing the cash flows of the entire business and dividing by shares outstanding. We fundamentally agree with this view but have also come to recognize that in reality owning a business and owning shares of a publicly traded company differ in an important way: A private business owner has direct control over his company’s cash flow, but public shareholders are wholly dependent on management to make capital allocation decisions on their behalf. The resulting lack of direct control over a company’s cash flow represents a blind spot in traditional cash flow-based valuation analysis. Left to the discretion of management—whose interests are less than perfectly aligned with shareholders—a company’s free cash flow might be deployed on any number of poor investments that do not add value for shareholders. Moreover, management controls the balance sheet, giving them discretion over company assets and the ability to borrow against future cash flows. In this document, we introduce a framework to help public equity investors evaluate management’s critical role as capital allocator.

Follow the Money

Management, through control of a company’s cash flow and balance sheet, has the power to create or destroy great value. For investors, there is nothing better than owning a stake in a high free cash flow company run by management that effectively redeploys excess capital. This combination has the potential to be a wonderful wealth compounding machine. Conversely, much wealth can be destroyed when free cash flow is frittered away and the balance sheet is mortgaged to make poor investments.

For these reasons, it is not enough to simply track and forecast free cash flow. Investors must work to understand how the cash is being deployed. Free cash flow distributed to investors is worth 100 cents on the dollar; free cash flow squandered is worth pennies on the dollar; and free cash flow effectively reinvested can be worth many multiples of its original value.

Because public shareholders are owners of a business managed by others, we believe they should take the time to get answers to some basic and important questions:

1. How much money (free cash flow) is the business actually generating?

2. Where is the money going (both free cash flow and balance sheet)?

3. If not paid to shareholders, was the money invested well on their behalf?

We offer a framework to address these key questions. Our observation is that although investors typically spend a great deal of time and energy forecasting earnings and cash flows, little time is devoted to examining how shareholder money is actually being used (or abused).

Owners’ Earnings

The fundamental premise that an asset’s intrinsic value is a direct function of the free cash flow it generates is widely accepted among both investment practitioners and finance academics. Discounted cash flow analysis is the cornerstone of corporate finance and investment theory. Benjamin Graham, considered by many to be the father of modern securities analysis, was an early teacher of the fundamental importance of free cash flow, referring to it as “owners’ earnings” in The Intelligent Investor, first published in 1949. His most famous student, Warren Buffett, has been clear on the subject: “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining lifetime.”¹

Free cash flow is the compensation business owners receive for the risks associated with ownership. It is the precious money left over after expenses have been paid and capital expenditures have been funded. It is not the same as earnings; a company might have to reinvest all its earnings (and more) back into the business just to maintain the status quo. If a business does not generate free cash flow, what benefit does ownership offer? There might be residual value in liquidating assets, but as an ongoing concern if there is no prospect of free cash flow, then there is no economic reason for ownership.

A Big Difference

The problem is that we have seen some high free cash flow companies deliver great returns for shareholders and others painfully disappoint. Over time we have come to believe that a key difference is management’s effectiveness as capital allocator, specifically the choices management makes with respect to the use of free cash flow and the balance sheet. Capital deployed effectively by management can drive impressive stock price performance, while poor allocation decisions can come at a high cost to shareholders.

Investing solely on the basis of free cash flow yield without regard for how the cash is being deployed is a little like choosing a job based on salary but only receiving a portion of the pay in a check and being unconcerned with where the remainder went. If an employee only receives half of his compensation in cash, he would naturally be keenly interested in what happened to the other half. Shareholders typically receive less than half of their company’s free cash flow in the form of a “paycheck” (dividend) and we think it would serve them well to look into what management does with the rest of their money. Shareholders own the cash flow and balance sheet, but management controls them. Management’s decisions about what to do with both can make a world of difference for shareholders.

Skeptics about the importance of management’s control over free cash flow and the balance sheet would do well to consider the extraordinary example of Berkshire Hathaway under Buffett's stewardship. Investors who bought shares of Berkshire Hathaway in 1965, the year Buffett took control, invested in a textile company that was in all likelihood on its way to bankruptcy. However, by the early 1970s, non-textile businesses—insurance, banking, and other investments—acquired by Buffett with Berkshire’s capital were accounting for essentially all of Berkshire’s earnings. If management had continued to reinvest shareholder capital back into the textile business, investors likely would have lost their entire investment. Fortunately for shareholders, Buffett proved to be an excellent capital allocator.

In our observation, Buffett has taken a unique approach with respect to acquisitions: He keeps management in place to run the business while he assumes the role of capital allocator. In the vast majority of publicly traded companies, however, there is no such division of roles. The same management team entrusted to run the business assumes the critical role of capital allocator almost by default. While in theory the board of directors is responsible for capital allocation decisions, we would assert that from a practical standpoint the relationship between management and the board typically gives management de facto control.

Although the importance of understanding how a company’s free cash flow and balance sheet are being deployed might seem rather obvious (at least we hope so by now), in our experience, few investors devote much time to this critical part of the value equation. Now the question becomes just how to go about it.

The DVS and Return on IM Framework

Given the importance of capital allocation decisions, we have developed a framework to evaluate management’s stewardship of shareholder capital. Our framework focuses on management’s use of free cash flow and the balance sheet. We start by observing that management can either distribute free cash flow to shareholders or reinvest it in an attempt to grow the business. If they do neither, it will be reflected on the balance sheet as an increase in cash or decrease in debt. Specifically, free cash flow, by definition, must go to one or more of the following uses:

• Increase in Net Cash or Decrease in Net Debt—Shareholders own the balance sheet, so additions to cash and reductions of debt add value dollar for dollar.

• Dividends—Checks directly paid to shareholders are the most straightforward (but potentially least tax efficient) way of returning value to owners.

• Share Buybacks—Only share buybacks that result in accretion—an actual reduction in shares outstanding—are a true return of value to shareholders. We will discuss this important distinction in more detail later.

Each of these first three uses provides what we refer to as Direct Value to Shareholders (DVS). They are relatively easy to calculate and measure. We can think of DVS as a straightforward mathematical formula:

DVS = Increase in Net Cash + Dividends Paid + Value of Accretive Buybacks

• Investments by Management—The fourth use of free cash flow is the most complex. We have labeled it Investments by Management (IM). It can be a real wild card, an area where management can create or destroy tremendous value for shareholders. In our methodology, IM is the portion of free cash flow that management is not allocating to one of the three components of DVS. It can meaningfully exceed free cash flow in any given year because management can use the balance sheet to make investments that are significantly larger than free cash flow. We note that although management is continually making “above-the-line” investments (for example, capital expenditures, research and development, and so on), these investments are already accounted for prior to arriving at free cash flow. We represent IM mathematically as:

IM = FCF – DVS

IM might prove to be better or worse for shareholders than DVS depending on the return on IM. We believe that a simple example will most easily demonstrate the usefulness of the DVS and return on IM framework in evaluating management’s allocation of shareholder capital.

An Example: Smoothies R Us

In our example, you buy a smoothie stand at the local mall, Smoothies R Us, and hire a nice guy named Jimmy to manage it while you are off doing other things. Assume you pay cash, say $50,000, for the business and the company has no debt. In year one, Smoothies R Us generates $10,000 in cash after all expenses (free cash flow = $10,000). If at the end of the year the company checking account balance is $10,000 higher and Smoothies R Us is still debt free, you know exactly where the money went—an increase in net cash. Perhaps instead, net cash remained the same but you received a dividend check for $10,000. Either way, you can be confident that your company really made $10,000 and you, the owner, benefited directly by that amount (DVS = $10,000). As a corollary, we can see that management (Jimmy) made no investments on your behalf (IM = $0).

IM = FCF – DVS

$0 = $10,000 – $10,000

Now, let us consider another scenario. You get a report showing Smoothies R Us made $10,000 but there is no increase in cash, you received no dividend and you see $15,000 in new debt on the company’s balance sheet. Now, you are not only looking for the $10,000 your company made, but you also want to know where the $15,000 that was borrowed went. You ask Jimmy what happened to your $25,000; he eagerly reports that he bought out a competitor, and you now own a second smoothie stand for a bargain price of $25,000. Now, instead of having $10,000 more in net cash at your company or a dividend check deposited into your personal checking account, your company is $15,000 in debt, and you own a second smoothie stand. The purchase of the additional smoothie stand represents an IM and you might or might not prove to be financially better off because of it.

IM = FCF – DVS

$25,000 = $10,000 – ($15,000)

Although DVS is always directly measurable, financial reporting rarely (if ever) offers sufficient granularity for direct measurement of IM. In addition, DVS might or might not be preferable to IM depending on the return on IM. High return IM is almost always a better use of shareholder capital than paying down debt, issuing dividends, or buying back stock.

Measuring Return on IM

We asserted early on that free cash flow is the ultimate source of intrinsic value. It follows, therefore, that growth of free cash flow is the best measure of the effectiveness of IM. We will extend the Smoothies R Us example to demonstrate our free cash flow-based methodology for estimating return on IM:

Jimmy (management) used your money (shareholder capital) to buy another smoothie stand. It is your company’s core business and not a crazy idea, but was it a good investment? The answer can be found in future free cash flow growth (or lack thereof). At this point, you only know that Jimmy invested $25,000 of your money. If, in the years ahead, Smoothies R Us continues to generate the same free cash flow as before ($10,000 annually), then it is reasonable to assume the $25,000 purchase of another smoothie stand provided no incremental return and therefore went to waste. You would have been $25,000 better off if Jimmy had simply paid you a dividend of $10,000 and did not put your company in debt by $15,000. If, on the other hand, free cash flow increased, to say $15,000 annually, you would have reason to be happy with Jimmy’s decision. We note that a $5,000 increase represents a 20% annual return on the $25,000 invested—perhaps Jimmy deserves a raise.

Return on IM = Increase in FCF / IM

20% = $5,000 / $25,000

Now it is certainly possible that the increase in free cash flow has nothing to do with Jimmy’s $25,000 investment of your money in another smoothie stand. Perhaps the original store, due to its wonderful location in the local mall, is attracting new customers in droves and producing all the growth. With a small business, this is easy enough to figure out. In the case of a much larger and significantly more complex publicly traded company, shareholders have a much more difficult task determining the true source of growth. Investors in companies delivering high free cash flow growth often have little choice but to give management the benefit of the doubt. However, the practical reality is that shareholders likely benefit by maintaining ownership regardless of whether the growth is the direct result of effective IM or due to other factors.

A Real World Sample Study

We utilized our DVS and return on IM framework to look at a group of public companies that we believed had potential to be attractive investments. As a starting point, we ranked a broad universe of companies by free cash flow yield. Next, we eliminated companies that were highly leveraged or operated in industries where we believed that historical performance might not be indicative of future prospects—newspaper companies and home builders, for example. Finally, we eliminated financial services companies due to concerns about the usefulness of free cash flow as a performance metric.

We performed our sample study with fiscal year data from 2002 through 2010. Free cash flow was averaged for years 2002 through 2004 to arrive at a beginning level free cash flow and years 2008 through 2010 to arrive at an ending level free cash flow. We used a 3 year average to mitigate the impact of single year volatility. To calculate return on IM, we divided the increase in average free cash flow by the cumulative IM for years 2002 through 2010. We show the results, ranked by return on IM, in Table 1.

Table 1 DVS and Return on IM: Sample Study ($ in millions)

Although we would assert that the DVS and return on IM framework is inherently logical and provides valuable insight into a complex and fundamentally important issue, we recognize that the methodology employed in Table 1 is subject to a certain amount of compromise, in part due to the annual variability of investments and free cash flow. For example, we have encountered situations where management made a substantial investment near the end of the data period. In these instances, return on IM might be understated. One of the most prominent examples of this in our study is Express Scripts (ESRX), which acquired WellPoint’s NextRx business in December 2009 for $4.7 billion. As a result, our analysis only includes 1 year of free cash flow from the acquisition, while including the entire purchase price in IM. A back of the envelope adjustment to correct for this yields a return on IM of 21% versus 15% as reflected in the table. We also encountered a handful of circumstances where growth in unfunded pension and other post-retirement liabilities were substantial enough to have a meaningful impact on our return on IM calculation. The most dramatic example of this in our study is Honeywell (HON). If we adjust HON’s IM from $12 billion to $17 billion to account for a $5 billion increase in unfunded pension liabilities over the 9 year period, the company’s return on IM falls from 14% to 10%. In light of the potential need for significant adjustments such as these, we would implore that the output be used as the starting point for further analysis, not the conclusion.

It is also important to note that there are a couple of circumstances where the return on IM calculation yields a number that is not meaningful. The first instance (we label as a green flag) is where 100% or more of free cash flow goes to DVS and therefore return on IM cannot be calculated because IM is equal to or less than zero. These situations can reveal some of the most attractive investment candidates. This is because when DVS exceeds free cash flow—and free cash flow is growing—it identifies businesses that have been able to grow without the need for reinvestment of free cash flow. The second instance (we label as a red flag) is when free cash flow declines over the period being analyzed. In this case, the formula does not yield a meaningful mathematical result because the larger the IM during the period, the smaller the free cash flow decline appears on a relative basis. However, declining free cash flow in the face of significant IM is cause for alarm; the larger the investment, the louder the alarm. In these situations, the DVS and return on IM framework reveals that either free cash flow might not be real or, at a minimum, IM have not yet yielded results. We believe large IM in conjunction with declining free cash flow is a dangerous combination for investors.

A Closer Look at Share Buybacks

Earlier we discussed the components of DVS. One of these, share buybacks, requires some additional attention. Buybacks are widely viewed as the most efficient way to return capital to shareholders as well as a sign that management believes the stock is undervalued. However, there are several issues to consider when looking at the impact on shareholders. For starters, evidence suggests that management is most comfortable doing buybacks when things are going well and the outlook is rosy. At such times, the stock is usually not a bargain. There are many examples of companies buying back stock in good times only to find it necessary to reissue shares at much lower prices to survive during bad times. Secondly, it has become commonplace for companies to buy back shares to offset dilution from employee stock-based compensation. Buybacks that offset dilution from employee stock plans are really just a substitute for cash compensation. Finally, share repurchases that offset dilution arising from stock-based acquisitions are IM and not DVS. Only share buybacks that result in accretion represent DVS, while buybacks that offset dilution represent IM. For these reasons, it is extremely important to investigate management’s use of share repurchases to see if they actually added value for shareholders, and if so, how much. We calculate contribution to DVS as follows:

Buyback DVS = (Beginning Shares – Ending Shares) x Average Price Paid for Repurchases

Even when buybacks result in accretion (DVS) the magnitude of shareholder benefit depends heavily on the price management pays when buying back stock. A decline in share price post-buyback diminishes the value of the repurchase for shareholders. In hindsight, shareholders would have been better off with a dividend or the full value of the cash remaining on the balance sheet and still available to buy back shares at the new lower price. Conversely, a buyback at bargain prices magnifies the value returned to remaining shareholders. In light of this, we offer the following formula to be used in conjunction with the Buyback DVS formula:

Price Impact = (Beginning Shares – Ending Shares) x (Current Price – Average Price Paid)

Although we have little interest in playing “Monday morning quarterback” relative to repurchase activity, we do think it is important to understand the true shareholder value implications of past buybacks.

Shareholder Value Created Through Buybacks: AmerisourceBergen

One company that stood out in our sample study for their effective use of share buybacks was AmerisourceBergen (ABC), one of the country’s largest pharmaceutical distribution and services companies. During the first 3 years of our study period ABC reported average annual free cash flow of $463 million compared to an average of $722 million for the last 3 years, representing a 56% increase. However, free cash flow per share grew by 144% over the period, from $1 to $2.44. How did this happen? Management used shareholder capital to reduce shares outstanding by 36%, from an average of 464 million shares at the beginning of the period to an average of 296 million shares at the end of the period. As a result, investors saw their percentage ownership—their claim on the company’s free cash flow and balance sheet—increase by 56% without purchasing even one additional share. Furthermore, from a price impact standpoint, we observe that over the period ABC paid an average of approximately $20 per share, well below the December 31, 2010 closing price of $34. By multiplying this $14 difference by the total reduction in shares outstanding of 177 million shares, we can calculate an approximate price impact of $2.5 billion over the 9 year period. This represents significant value creation for remaining shareholders, as it is equal to roughly 25% of ABC’s market value as of year-end 2010. From 2002 through 2010, management also paid over $300 million in dividends and reduced net debt by $1.6 billion. It is interesting to note that over the study period shareholders experienced a compound annual total return of 7.1% compared to 3.0% for the S&P 500. In our view, growing ownership in a growing business is a wonderful way to compound wealth, and we believe a key driver behind ABC’s outperformance over the period.

High DVS and High Free Cash Flow Growth: Brown-Forman

One company that stood out for an attractive combination of high DVS and high free cash flow growth was Brown-Forman (BFB), a Louisville-based company best known for Jack Daniel’s whiskey. When we use the framework to analyze BFB, we see that free cash flow at the beginning of the period averaged $180 million compared to $478 million at the end of the period for an increase of approximately 166%. Furthermore, the company delivered a total of $1.8 billion in DVS, or more than 60% of total free cash flow over the period. This $1.8 billion was comprised of approximately $1.4 billion in dividends plus more than $0.7 billion in accretive share repurchases, reduced by an increase in net debt of roughly $0.3 billion. With respect to share repurchases, over the period BFB reduced shares outstanding from 171 million to 148 million, representing a 13% decrease. Moreover, an analysis of the price impact of the buyback reveals an additional $800 million of value created for remaining shareholders. We believe that high DVS in conjunction with high free cash flow growth is a powerful combination for investors. We note that over the 9 year study period shareholders enjoyed a compound annual total return of 12.6% compared to 1.3% for the S&P 500. ²

The Framework as an Early Warning System: WorldCom

We decided to look at WorldCom, a well-known shareholder disaster, to see if our framework would have been helpful in identifying problems before they were recognized by the broader investment community. In the late 1990s, WorldCom became a veritable Wall Street darling, with many investment firms recommending shares as a “core” holding. The stock was a stunning performer, appreciating from $5 in mid-1994 to a high of $62 in mid-1999. With the company’s revenue and EBITDA growing from $2.2 billion and $341 million, respectively, in 1994 to $17.7 billion and $4.9 billion in 1998, WorldCom appeared on the surface to be a terrific investment opportunity.

In applying the DVS and return on IM framework to WorldCom, red flags were apparent well before the stock began its precipitous decline. Specifically, from 1994 through 1998, WorldCom generated a negative $2.2 billion in cumulative free cash flow. Because WorldCom’s acquisition of MCI occurred late in the period studied, we adjusted the debt balance and share count to exclude the cost of this $37 billion purchase. Table 2 reflects this analysis and clearly reveals that the company had done a poor job of delivering return on IM. Specifically, during the period, net debt (prior to the MCI purchase) increased by approximately $16 billion, the dollar amount of shares outstanding increased by nearly $25 billion, and the company paid no dividends. As a result, DVS over the period was negative $41 billion. Meanwhile, average free cash flow at the end of the period was negative $1.3 billion compared to a positive $171 million at the beginning of the period. Declining free cash flow in the face of significant IM is a red flag under our framework. We believe that investors performing this analysis would have had good reason to avoid WorldCom shares well before the stock ultimately collapsed in 2000.

Table 2 DVS and Return on IM: WorldCom ($ in millions)

A Closer Look at Management Compensation

Previously, we established that free cash flow is the compensation business owners are due for the risks associated with ownership. Therefore, we believe management compensation should be evaluated relative to free cash flow as well as the key components of our framework—DVS and return on IM. In our view, excessive compensation can be an important sign that management might be placing its own interests ahead of shareholders. Regardless of whether it takes the form of cash or stock, management compensation comes out of shareholders’ pockets.

Although the board of directors is responsible for setting CEO pay and shareholders ultimately approve board membership, shareholder influence over the board pales in comparison to management’s. Not only does the CEO often serve as chairman, board members are typically handpicked by management. Furthermore, the generous compensation and benefits received by board members serve as powerful incentives to reward those responsible for getting them their board positions. In a similar way, paid compensation consultants also stand to benefit from rewarding those responsible for hiring them.

Although excessive compensation can be a red flag, high levels of stock ownership can be a green flag. There is nothing mysterious about this: Compensation represents a conflict of interest, while share ownership represents a partnership of interest. Managers with large ownership stakes and relatively modest pay packages are arm-in-arm with shareholders relative to risk and return. For this reason, in addition to comparing compensation to free cash flow, we suggest comparing compensation to stock ownership.

Important Considerations Outside of the Framework

We have offered the DVS and return on IM framework in an attempt to help investors track management’s use of free cash flow and the balance sheet and to evaluate management’s effectiveness in serving shareholders. We offer the framework as a valuable tool rather than a “magic formula.” There are, of course, other important considerations that investors should incorporate into their analysis.

We would suggest that first among these is a need to fundamentally understand the business. An understanding of the economics and durability of competitive position is necessary in order to estimate the sustainability of results. After all, investors benefit from future free cash flow, not past results, and historical numbers are only valuable to the extent they provide insight into the future.

Another critical issue is price. A strong company with growing free cash flow can be a poor investment if the price is too high, even if effective capital allocation practices are evident. By using valuation models that incorporate free cash flow yield in conjunction with expected growth, investors can address this key consideration.

Conclusion

We have put forth our view that management’s use of free cash flow and the balance sheet is of critical importance to investors. We identify free cash flow as the fundamental source of intrinsic value and offer a framework for evaluating management’s effectiveness in deploying capital on behalf of shareholders. Companies that demonstrate high DVS and high return on IM merit further analysis as they might represent promising investment opportunities. Companies that rate poorly on these metrics should be viewed with skepticism by investors. We also highlight important issues relative to share buybacks and discuss why they often do not add as much value for shareholders as widely thought. Finally, we suggest that investors evaluate management compensation relative to the value of management’s equity stake in the business as well as free cash flow, which is effectively owner’s compensation. We believe that our framework addresses fundamentally important investment considerations, and it is our hope it serves as a foundation for further in-depth analysis.

Endnotes

1 The Essays of Warren Buffett: Lessons for Corporate America (2001), p. 200

2 The S&P 500 return used in the BFB and ABC examples are different due to differences in fiscal year ends.