A basic takeaway of cashflow based valuation is that the longer a company generates healthy free cash flow growth, the higher its intrinsic value. Our longevity framework helps in assessing, using objective parameters, how long a company is likely to sustain healthy growth in free cash flow.
For younger, smaller companies (aka the Little Champs), after a particular size and scale is attained, incremental growth in operating profits and improvement in capital efficiency results in much higher growth in free cash flow. This is also corroborated by strong free cash flow growth generated by companies like Astral Ltd. and Relaxo Footwears Ltd. in recent years. Given this non-linearity, free cash flow, rather than measures like earnings, should be the primary input for determining the intrinsic valuation for high-quality small-caps.
Understanding Free Cash Flow From A Company Lifecycle Perspective
A typical firm’s life cycle consists of four stages – Nascent, Growth, Maturity, and Decline.
Free cash flow is calculated as the difference between operating profits generated by the company for the year and the amount reinvested back into the business (investments into working capital and fixed/intangible assets). These key determinants and thus the quantum of free cash flow is significantly influenced by the stage of a company’s lifecycle as shown in the exhibit below.
In the Nascent phase, the company’s revenues are growing but are small and insufficient to cover the operating costs (most of which are fixed and to an extent front-ended in nature), resulting in operating level losses. However, at the same time, the company needs to give credit to its customers, build inventories and invest in capacities. Non-existent operating profits but inevitable investment needs lead to reliance on outside cash flows (equity or borrowings) to stay afloat and grow. Free cash flow is deep in the red in this phase.
In the Growth phase, as the company reaches a decent size and scale, operations start becoming profitable as growth in revenues outperforms the growth in costs. However, given the healthy growth prospects (driven by market and/or market share expansion), a large part of operating profits needs to be reinvested back into the business. Hence the growth in operating profits doesn’t fully translate into free cash flow growth – in fact, free cash flow could even be negative during the early part of the growth phase. However, as the company continues on its growth journey, operating profits start becoming sizeable enough to cover the working capital and capex needs, resulting in free cash flow turning positive and starting to grow exponentially (and much faster than operating profits).
The revenues and profits of the company hit their peak in the Maturity phase. So does the quantum of free cash flow as reinvestment needs to ebb off due to plateauing growth. The peak in free cash flow usually supersedes the peak in operating profits.
As growth opportunities dwindle, competition intensifies, and/or redundancy in products sets in, the company enters the Decline phase. Revenues and operating profits start on a descending journey, followed eventually by the cash flows.
The fair (or intrinsic ) of a company is the net present of all its expected future free cash flow over its life cycle. The future free cash flow that the company generates over its lifecycle is in turn dependent on the length of the free cash flow curve (i.e. the longevity of the cash flows) and the slope of the free cash flow curve (i.e. the growth in cash flows).
Investment Process And Frameworks To Own Companies Maximising Free Cash Flow Generation Over Their Life Cycles
At Marcellus, we typically stay away from companies at the Nascent stage of their evolution. For these companies, their relatively short operating track record does not give us the required conviction regarding their governance, long-term cash generation ability, etc. Our research process and in particular our quantitative filters with minimum thresholds around the history of the company, its forensic accounting quality, and its capital allocation normally weed out such early-stage companies.
Similarly, we stay away from a franchise that is past its prime and hence witnessing a plateauing of its growth rates or even an actual structural decline in its operating profits/cash flows. This plateauing or decline in free cash flow could be a result of several factors like demand saturation for company’s products, technological disruption in its business, or reflective of lethargic management letting the company be competed against or disrupted away or lacking the vision of taking mitigating steps like adding new growth initiatives in time. Here too, our investment process, more particularly our longevity framework (shown in the flow-chart below) helps us to stay away from such stocks during our new stock selection process as well as to detect early signs in our existing portfolio companies.
However, all companies don’t follow the typical free cash flow pattern shown in the first chart. Great companies generate several decades of growth in free cash flow i.e. remain in the ‘sweet spot’ phase for decades. Some of the factors that positively impact the longevity and growth in the free cash flow of a company as assessed through our longevity framework are:
Inherent advantages enjoyed by the company like strong pricing power (i.e. strong moat).
Focus on operating efficiencies (how the firm achieves the same revenues as its competitors but with lower expenses).
Prudent capital allocation/adding profitable new growth initiatives.
Softer aspects around management quality and succession planning.
In summary, using an objective set of parameters, our longevity framework helps in assessing how long the company is likely to sustain the healthy growth in free cash flow and a company’s score in the longevity framework forms an important basis in deciding not only whether a company makes it to/remains in the portfolio but also the inter-se position sizing amongst the portfolio companies.
Sweet Spot Can Get Even Sweeter For Younger Companies Like The Little Champs
While we steer clear of nascent companies, we look to invest into well-managed market-leading franchises with a healthy return on capital employed but currently ‘suppressed free cash flow’ due to high reinvestment needs (due to investment in working capital and fixed assets). In fact, most of the Little Champs companies fit this definition where they have built a track record of consistency in profits but are still witnessing somewhat year-on-year volatility in free cash flow generation. Such inconsistency in the free cash flow generation usually inhibits analysts from using that metric for arriving at the intrinsic for smaller/young companies.
However, we believe replacing free cash flow with other proxy metrics like earnings ends up underestimating the intrinsic of the franchise.
This is because of the following reasons:
As these companies achieve scale, operating profits start becoming sizeable enough to cover the working capital and capex needs. This not only results in free cash flow moving into a consistent positive zone but also brings about non-linear growth in free cash flow as more and more incremental operating profits flow through into free cash flow. This non-linearity in free cash flow generation—which you can see in the first chart—does not get captured in earnings growth.
Many well-run companies irrespective of their lifecycle proactively focus on generating efficiencies around working capital (for instance, investing in an inventory management system that helps bring down the level of inventories) or fixed assets investment (better throughput from automation of the production line). These efficiencies are again not fully captured in a measure like earnings growth.
The result of the above is that, after a particular size and scale, every unit of incremental growth in operating profits results in much higher growth in free cash flow. In such cases, free cash flow estimation becomes all the more relevant and important.
The importance of using the metric is also underpinned by the growth in free cash flow in some of Marcellus’ portfolio companies like Astral, Relaxo (which are not part of the Little Champs portfolio but are part of other Marcellus portfolios) in recent years.
Both these companies have a good operating profit track record but had inconsistent free cash flow generation until few a years ago. Now they have turned into consistently strong free cash flow generating machines in recent years as we show in the exhibits below due to the precise reasons mentioned under points 1 and 2 above.
Conclusion
The examples of Astral and Relaxo highlighted above indicate there is a lot of in building long-term free cash flow projections of companies rather than indulging in the standard profit-based valuation multiples that most investors use.
Our longevity framework which focuses on specific management actions surrounding increasing the longevity and growth of the free cash flow gives us an objective way of determining the long-term free cash flow compounding for high-quality smallcap companies.
Note: Relaxo and Astral Poly are part of most of Marcellus’ portfolios.
Saurabh Mukherjea, Ashvin Shetty, and Harsh Shah are part of the Investments team at Marcellus Investment Managers. Saurabh Mukherjea is the co-author of “Diamonds in the Dust: Consistent Compounding for Extraordinary Wealth Creation”.
The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.
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