Do you remember the story of the three little pigs?
The first little pig built his house with straw, only to see the wolf blow it down. The second pig built his house with sticks and suffered the same fate.
The third pig built his house with bricks. The big, bad wolf huffed and puffed, but he couldn’t blow it down.
So what’s the lesson investors can draw from this story?
Well, it is that in corporate finance, cash is the equivalent of bricks. In fact, smart investors lay a lot of emphasis on companies that generate a plenty of cash as these are in the best position to withstand the huffing and puffing of a slowing economy and competition.
The best thing about cash – that most companies often overlook – is that it has ‘optionality’.
Having cash on hand in a volatile market gives you the flexibility to purchase assets in the future at discounted prices.
Cash is best when it’s ‘free’
The best things in life are free, and the same holds true for cash.
Smart investors love companies that produce plenty of free cash flow or FCF.
But what exactly is FCF?
Well, let me help you with a simple explanation.
To produce sales or operating revenue, a company incurs operating expenses. Like it spends money as salaries for employees, sales and marketing costs, and research and development costs.
The difference between operating revenue, that is what the firm receives from customers on selling its products or services, and operating expense, the list of things above, is called Operating Income or Net Operating Profit (NOPAT).
Now, apart from the above-mentioned expenses, a company also must buy machinery, buildings, tools, and other things. It must invest money in real estate, buildings, and equipments.
Also, the company needs to buy inputs for its production. It has to buy steel if it wants to produce cars. In financial terms, a firm has to purchase working capital to support its business activities. On top of that, a company must pay income taxes on its earnings.
The amount of cash that is left over after the payment of all these expenses, investments, and taxes is known as Free Cash Flow or FCF.
A high and rising FCF generation signals a company’s ability to pay debt, pay dividends, buy back stock and facilitate the growth of business – all important things from an investor’s perspective.
When a company’s share price is low and FCF is on the rise, there are great chances that earnings and share value will soon be on the up.
By contrast, falling FCF signals trouble ahead. In the absence of decent FCF, companies are unable to sustain earnings growth as they don’t have much of free cash for growth and expansion.
An insufficient FCF for earnings growth can force a company to boost its borrowing levels. Even worse, a company without enough FCF may not have the liquidity to stay in business.
India’s most consistent cash generators
Indian companies have seen very good times over the past 8-10 years, when there sales and profits have grown at a fast pace.
However, not all of this profit growth has fallen through into free cash, as companies have also spent a lot of money on expansion – adding new factories, offices, sales offices, and employees.
This has meant that while profits have grown at a good pace, free cash flow has not been able to keep pace. This is validated by a mere 2% average annual growth in free cash flow of the Sensex companies (excluding banks and financial institutions) over the past 9 years.
However, there have been several companies – as you can see in the chart below – that have been strong free cash generators over these years.
Data Source: Ace Equity, Safal Niveshak Research
Sun Pharma, the leading pharmaceutical company, has for instance grown its free cash flow at an average rate of 26% per year over these 9 years.
India’s leading steel manufacturer, Tata Steel, isn’t far behind, with a 24% average annual growth in FCF during this period.
And then there are the leading IT companies – Infosys and Wipro – that have grown their FCF at rates of 23% and 19% respectively.
So what has caused these companies to generate so much free cash flow, and so consistently, over such a long period of time?
Companies that experience rising FCF generally do it through consistent growth in sales, continuous improvement in profitability and productivity, and reduction of debt.
These factors also explain why these companies have been able to earn high FCF year after year.
Their managements have focused on having high profit businesses more than mindless pursuit of higher market shares.
They have not made undue expansions, and have not resorted to unnecessary borrowings.
Overall, these companies have been prudent in the way they have grown, and have not sacrificed shareholders’ interests along the way.
This is what great companies are made up of. And such are the companies investors love to invest in, though only at the right price.
Disclaimer: The author of this post, or any of his family members, does not own any stocks mentioned herein. The opinions in this post are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies is not an indicator of the future. The information in this post is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.