My Fundamental Process: Part Two

My investment process usually starts with the cash flow statement as I look at free cash flow. That is the cash a business throws off less anything they spend on capital expenditures (Capex). Why eliminate the cash they spend on Capex? Because it is difficult for me to tell the difference between Capex that is necessary to maintain the business and Capex that is truly a new investment. For instance, Fedex needs to keep buying new trucks so its not an optional expenditure.

Another reason I heavily rely on free cash flow is that it is quite easy to manipulate earnings per share. It is a lot harder to fake cash flow over the course of many years. Cash does not lie.

There is usually a reason why a company trades cheaply and one must make sure that the cash flow will continue. Such questions that must be asked are as follows
  • Is the company in secular decline? If the company has a product that might be made obsolete or is in an industry that is in decline than the low multiple might be justified. 
  • Is the industry the company is in cyclical? How bad would a downturn in the economy hurt free cash flow?
  • Does the company have a strong enough capital structure to withstand a rough period?
  • Can the management be trusted to return the cash to shareholders or invest it wisely? Or will they burn the cash on bad acquisitions and the likes?
  • Are the cash flows unsustainable for any other reason?
  • Is there a catalyst to bring out the value? Do I get paid a dividend while I wait? Are they buying back shares?
Anybody running a screen can identify companies with a low price to free cash flow ratio. The harder part is answering the above questions.

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