Global equities process insight: Value or Value trap?

A crucial part of our process when evaluating companies is understanding free cash flow production. Sometimes companies that can appear to be incredibly good value turn out to be value traps.

In this example we will take two companies to demonstrate the importance of fundamental research when evaluating companies.

Broadcom is a semiconductor and software company, and Goodyear is a tyre manufacturer similar to Bridgestone.

In January 2021, Goodyear was trading on only 3x P/E, Broadcom was trading on 26x P/E. Knowing nothing more about these companies you might think Goodyear is a better investment…

We think long term Free Cash Flow production is the best way to value a company. Therefore, our process on the Global Equities Team is to value all of our companies on the Free Cash Flow per share they produce in 3 to 5 years time, plus all of the accumulated dividends we receive.

What is Free Cash Flow?

Free cash flow (FCF) is the money a company has left over after paying its operating expenses and capital expenditures.

Companies that pay sustainable and growing dividends typically produce sustainable Free Cash Flow growth. This is because to pay a sustainable and growing dividend a business must have a healthy balance sheet and generate sustainable and growing Free Cash Flows.

Perhaps, unsurprisingly then, the starting point for all of our proprietary models are a company's reported Net Income and Free Cash Flow from their annual reports (10K). A focus on bottom-up stock research and proprietary Free Cash Flow forecasting is critical because it is a company's future free cash flow that rewards shareholders. Thus, we must make forward looking judgements about free cash flow generation and the price we pay for that.

We have turned the annual reports into simplified Income Statements and Free Cash Flow Calculation for both Goodyear and Broadcom. We have then adjusted these reported figures to determine what is sustainable Free Cash Flow for the companies.

Assessment:

In our view Broadcom was much cheaper than Goodyear. Broadcom was on 13x Price to Free Cash Flow, and Goodyear was on 29x Price to Free Cash Flow.

In layman's terms, for every $100 of Net Income, Goodyear only made $10 of Free Cash Flow (10% conversion ratio). This means that Goodyear is on a PE ratio of 3x, but a Free Cash flow ratio of 29x.

Meanwhile, Broadcom turned every $100 of Net Income into $115 of Free Cash Flow! This means that Broadcom was on a PE ratio of 26x but a Free Cash Flow ratio of 13x.

This happens for many reasons:

• Goodyear pays a very low tax on profits, but a much higher tax on cash profits.
• Goodyear is a “low quality” business that is undergoing a restructuring. This means that they must pay cash to restructure their business (plant closings and redundancy settlements).
• Goodyear must pay cash to top up their pensions for employees as they were underfunded.
• Goodyear must pay leases which they did not report in their profit and loss account.
• Goodyear is a very capital intensive business and they must buy new equipment to grow production.

On the other hand:

• Broadcom pays a lower tax on profits than cash, so there is a higher cash tax rate.
• Broadcom takes all restructuring charges in the Income Statement so there are no additional cash charges.
• Broadcom takes all leases charges in the Income Statement so there are no additional cash charges.
• Broadcom is not capital intensive because they outsource manufacturing to TSMC. This allows Broadcom to focus on design and software.

Why does Free Cash Flow matter so much?

Free Cash Flow is so important because companies pay for R&D, Capex, Acquisitions, Dividends and Buybacks in cash, not profit. It is these factors that generate future sales and cash flow growth. Which in turn generate future long term share prices.

What happened next?

Goodyear continued to generate very little Free Cash Flow: despite generating a total net income of $277m in the 3 years to 2023, their free cash flow was -$477m! As a result, they did not pay any dividends, buyback any shares or make any acquisitions.

Over that same period, Broadcom continued to generate very large amounts of Free Cash Flow: they generated a total net income of $32bn, with free cash flow generation of $47bn! As a result, they were able to grow their Free Cash Flow by continuing investing in R&D and products, whilst paying out large dividends ($20.9bn), repurchasing shares ($11.5bn) and they made a $61bn acquisition that at the end of 2023 that will be reflected in the 2024 accounts.

What did this mean for investment returns?

Ultimately, it is a company's cash investments in SG&A, R&D, M&A and capex that drive its future sales and Free Cash Flows. We as shareholders also benefit from increasing dividends and repurchases. These investments and shareholders returns can only be made out of cash, not profit. Therefore, it is our firm belief that Free Cash Flow per share growth plus dividends accumulated is what drives long term share prices.

In the very short term, share prices are almost random: Goodyear (GT) actually outperformed Broadcom (AVGO) dramatically in 2021. However, in the long run, the market rewards sustainable Free Cash Flow growth: at the time of writing, Broadcom has outperformed Goodyear by around 196% since the start of 2021.

If you extend your time frame out even further, you can see just how much the market cares about Free Cash Flow and dividends. In the end, this is all that matters.

Since Broadcom's IPO in 2009, the shares have compounded at 38% which is roughly in line with its FCF per share growth since IPO (32% CAGR) plus its dividend yield (2%). Over that same period, Goodyear shares have compounded at -2%…this makes sense because they have generated no Free Cash Flow per share growth.