Finding & Predicting Value in the Stock Market
How I approach intrinsically valuing the companies in my portfolio.
“Let me be clear about cash flow - it’s the only thing I care about because there is no business without cash flow. You might be able to last for a couple of years, but if you don’t have cash flow, you’re going to zero.”
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In this post, we’ll cover:
How I try and interpret a company’s intrinsic value
An example of this interpretation in action
Applying it to my 2022 investing strategy
How I Try to Interpret a Company’s Intrinsic Value:
It’s a term that I believe can be loosely defined as “the present value of all future cash flows the business can provide its owners, discounted at the cost of capital.”
Think about it like this - a business is simply worth all of the cash it can produce for its shareholders throughout its lifetime.
For example, if I know for a fact that a business, from inception to dissolution, will provide $100 million in free cash flow for its owners - the business is worth $100 million, period.
Now of course, there’s absolutely no way for us to know exactly how much free cash flow a business will produce throughout its lifetime with complete confidence. But, we can make certain assumptions and take some educated guesses.
Put very simply, buying stock in businesses that are trading lower than their perceived intrinsic value is my investing strategy.
“In 10 years, a business will be producing this much in free cash flow. Historically speaking, the market puts a 30X multiple on that figure. Currently, the stock is trading as if they’ll only produce this much - assuming I’m correct about their future free cash flows, the stock is undervalued.”
Taking a step back - let’s quickly run through exactly what free cash flow is.
According to Investopedia (linked above), free cash flow represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets - as well as changes in working capital from the balance sheet.
Think of it like this - free cash flow is how much more you have in the bank after you run your business throughout the year.
$10 million in the bank January 1, 2021.
$13.5 million in the bank December 31, 2021.
Our business produced +$3.5 million in free cash flow throughout the year - assuming we already paid for everything to support our operations.
This $3.5 million is the cash that’s readily available to repay our creditors or pay dividends and interest to our investors. Both equally as important.
Now let’s try and understand how we begin to replicate this strategy across different businesses - given that each business is wildly different.
Total number of shares outstanding.
If I have a business that has 10M shares outstanding and produced $10 million in free cash flow - that business produced $1.00 of free cash flow per outstanding share of stock.
If I have a business that has 20M shares outstanding and produced $15 million in free cash flow - that business produced $0.75 of free cash flow per outstanding share of stock.
The second business produced more free cash flow - but less free cash flow per share, hence is a less attractive investment in the eyes of an investor. Think about it, would you rather own stock in a business awarding you $1.00 in free cash flow per share, or only $0.75 in free cash flow per share?
$1.00 in free cash flow per share (henceforth ‘FCF/share’).
FCF/share is every single company’s north star.
To quote Jeff Bezos in his 2004 Letter to Amazon Shareholders:
Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share.
Why not focus first and foremost, as many do, on earnings, earnings per share or earnings growth? The simple answer is that earnings don’t directly translate into cash flows, and shares are worth only the present value of their future cash flows, not the present value of their future earnings.
Future earnings are a component—but not the only important component—of future cash flow per share. Working capital and capital expenditures are also important, as is future share dilution.
Though some may find it counterintuitive, a company can actually impair shareholder value in certain circumstances by growing earnings. This happens when the capital investments required for growth exceed the present value of the cash flow derived from those investments.
Amazon.com’s free cash flow is driven primarily by increasing operating profit dollars and efficiently managing both working capital and capital expenditures. We work to increase operating profit by focusing on improving all aspects of the customer experience to grow sales and by maintaining a lean cost structure.
As to dilution, total shares outstanding plus stock-based awards are essentially unchanged at the end of 2004 compared with 2003, and are down 1% over the last three years.
During that same period, we’ve also eliminated over six million shares of potential future dilution by repaying more than $600 million of convertible debt that was due in 2009 and 2010. Efficiently managing share count means more cash flow per share and more long-term value for owners.
This focus on free cash flow isn’t new for Amazon.com. We made it clear in our 1997 letter to shareholders—our first as a public company—that when “forced to choose between optimizing GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”
Amazon’s free cash flow per share from 2012 - 2020:
Their stock’s performance over this time period:
As we, the investors, discover that a business will and is producing more FCF/share for their shareholders - the value of that business increases. This makes sense, because remember.. a business is only worth the present value of all future cash flows the business can provide its owners, discounted at the cost of capital.
Applying Free Cash Flow per Share to Long-Term Winners:
Hopefully by now you understand where I’m coming from and how I try to find value in the markets.
Create conservative 5-10 year assumptions about a company’s free cash flow and their total number of diluted shares outstanding
If those assumptions were to come true, determine exactly what their stock price should be trading at today
If it’s currently lower than my “fair value” determination, buy. If it’s higher, hold. If it’s insanely high, take some money off the table.
We’ve talked about this company for several months now, with our most recent work on the stock linked below.
Marqeta will do $700 million in revenue next year, and over time will expand their free cash flow margin to about ~20%. Assuming ~550 million shares outstanding, you’re looking at about $0.25 in FCF/share.
If we assume the company will be growing FCF/share by about +35% annually given continued revenue growth and margin expansion, we’re hovering around $0.83 in FCF/share by year 5.
The market tends to put a 35X multiple on this figure.
$0.83 in FCF/share multiplied by ~35X = $29 / share
Marqeta, according to my free cash flow growth assumptions, is undervalued if trading below $29 / share - right now the stock is hovering around $19 / share.
Of course, the company has risks and all of my assumptions could fall apart between now and 2026 - but if we’re right, we’re right in a big way.
Applying this to My 2022 Investing Strategy:
In the post below, I shared my plan to do some tax-loss harvesting and begin switching up my “growth” portfolio - allocating capital toward “Mega-Cap,” “Mid-Cap,” and “Moonshot” stocks.
Despite some companies being considered extremely valuable (Facebook is a $885 billion company), they still have room to run from a FCF/share perspective.
Today, Facebook is trading around ~26X price to FCF/share.
($330.00 / $12.62 = 26X)
Historically speaking, we know this metric is the main driver of share price for Facebook - and every other company for that matter.
We also know that in 2014 their FCF/share was $2.10 and their stock price was $80 / share - or about that ~35X multiple I alluded to before.
2015 was ~38X, 2016 was ~30X, 2017 was ~31X .. you all sort of seeing a trend here?
But right now, it’s only ~26X.
FCF/share will continue to grow +30% annually for this company - they’re not going away anytime soon, and they just solidified their commitment to Web 3.0.
This is exactly how I’m approaching my 2022 portfolio build - disregard “company size” and instead focus entirely on potential FCF/share growth and how that translates into stock price appreciation.
All while leaning into secular growth trends and keeping a long-term mentality.
If you’re still not feeling very confident - that’s ok! I suggest reading this post, which clearly and succinctly breaks down how I approach building wealth - step by step.
Don’t forget - free cash flow per share to me (and many other investors) is the most important factor when making an investment decision. Of course, there are several other important factors to keep in mind - which we touch on throughout the posts linked out throughout this breakdown.
With that being said, it’s time to be incredibly strategic and disciplined as we approach the end of the year.
Disclaimer: This is not financial advice or recommendation for any investment. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.