Focus On Free Cash Flow On Invested Tangible CapitalThe Acquirer's Multiple
During his recent interview with Tobias, Kyler Hasson, Portfolio Manager at Delta Investment Management discussed Focusing On Free Cash Flow On Invested Tangible Capital. Here’s an excerpt from the interview:
Tobias: How are you thinking about valuation in that context, though? I’ve got your portfolio in front. It’s still a reasonably traditional value portfolio. It’s not at the super growthy end of value, which I talk to a lot of guys who’ve got a lot of compounders in there, who are a lot of SaaS companies, which still falls within the definition of value the way that they’re defining value. It just depends on how you’re treating that growth. So, I look at yours and this is not an uncommon collection of businesses. So, you’re still thinking about value in some context, how are you doing it?
Kyler: Yeah, that’s a good question. For me, actual valuation, I think a lot of people make it complicated. I don’t think it has to be super complicated. It’s cash in, cash out. So, for me, I really, really focus if I’m going to own anything, what are the cash flow characteristics of this business? Everything I own, I hope that I plan for it to grow. I don’t own sort of distressed situations or anything like that. So, if this company is going to grow, my first question is, well, how much capital does it need to grow? I think that’s– if you have a price to earnings multiple, it doesn’t always tell you that story, and the bridge from price to earnings to free cash flow is return on invested tangible capital is what I look at.
So, I want to make sure, well, P/E ratio is 13 and it’s going to grow 4% or 5% and so that should be good. Well, what’s the return on tangible capital? How much of those earnings if you’re going to grow with that 5%, do you need to retain? If the return on invested capital is low enough, it could be a lot. Most people will look at the Capex needs of the business. I look a lot at working capital.
Heico is a name that I own. They generate about 500 million pre-tax and their working capital’s around that same number, about $500 million. So, if you think, well, Heico is going to double its revenue and earnings in five years, well, you’re going to need to retain $500 million in working capital, most likely. So, I really try to track those cash flows, if they’re going to use leverage, will they increase it with earnings, all these things. From there, it’s how much do I think the company can grow? What portion of its earnings does it need to grow? And that gives you your free cash yield and an estimate for growth, and I just sort of add them up.
So, if something is– if I think it can grow over a long amount of time at 5%, and the P/E is 10, but at that growth, the free cash yield of 7, then I’m saying, “Well, I think I can make seven plus five.” I don’t do super complicated modeling. But I do try to be really reasonable and how I think about that long-term growth. Make sure I’m not being really aggressive with my assumptions obviously, I try to be conservative, like most other people.
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