There are four key drivers of free cashflow in a business – revenue growth, profit margins, working capital efficiency, and asset turnover. The order of importance across these four drivers differs across businesses. As our investee companies invest in technology to improve operational efficiencies, compress working capital cycles and expand their asset turnover, these companies are able to scale their franchises whilst avoiding price hikes. For such companies, growth in free cashflows can remain higher than growth in profits over long periods of time. Hence, investment in such companies purely by building expectations around their profit growth is an incomplete exercise. Investors Need To Evolve As Nature Of Business Changes
The valuation of any business is the net present value of all expected free cashflows in the future. As a result, for every business, an investor needs to build their expectation of the quantum of growth and the longevity of growth in free cashflows. This is a universal concept that applies to every business.
However, what is not common across businesses is the primary driver of free cashflows, which particularly affects the quantum of growth in free cashflows. Consider the following examples.
Type 1 – Book value as the primary driver of free cashflows: Let’s assume that there is a business that has a unique manufacturing process in a factory that produces a product that meets an essential demand of a large customer base. Furthermore, let’s assume that no competitor can produce a substitute product to meet this customer demand. As the business reinvests capital to expand its manufacturing capacity (plant and machinery), it delivers growth in free cashflows. To invest in such a business, investors must focus on growth in its asset base as the primary driver of its moat and hence free cash flows in the long term. Until half a century ago, investment in many great businesses was carried out on this basis, when the price-to-book multiple was a commonly followed metric.
Type 2 – Profits as the primary driver of free cashflows: Let’s say there is a business that has an exceptionally strong brand recall that cannot be replicated by a competitor. Since there is nothing differentiated about its product quality, the business outsources the entire manufacturing process, and hence it is an ‘asset-light’ business. The primary moat of such a business is its ‘brand’. At the simplest level, the more this business advertises its brand across various media channels, the more it delivers volume growth, revenue growth, and hence profits growth. Investing in such a business requires focus on only the ‘profit and loss’ statement – how much of profits from a given year get reinvested in advertising next year. Over the last 40 years, as penetration of mass media increased across countries, there were several such great businesses. It is not worth considering the P/B multiple for such a business – its P/B multiple will keep rising as the business grows because the business is outsourcing its ‘B’. Instead, the price-to-earnings multiple is more relevant for such a business. Here is an interesting comparison of two different businesses from the same industry on P/B multiples – Proctor and Gamble (the parent listed in the United States) and Colgate Palmolive (the parent listed in the U.S). P&G has grown its business through numerous acquisitions. These acquisitions have brought significant goodwill onto its balance sheet. On the other hand, Colgate-Palmolive has a negative accounting book value because its most valuable assets are the brands it has developed in-house over its hundred-plus years of existence. Hence, P&G looks cheaper based on a P/B multiple compared to Colgate because the denominator is much bigger in the case of P&G. The two companies are in the same industry, but given the differences in their capital allocation approach, one looks significantly cheaper than the other on P/B multiple and that highlights the irrelevance of P/B.
Let’s now move forward another step to see businesses that have evolved even further and thus made the P/E multiple irrelevant. Let’s understand this more through a third type of business.
Type 3 – Operating efficiencies as a key driver of free cashflows: What if a business significantly reduces its working capital cycle and increases its asset turnover through a variety of initiatives, consistently over the next 20 years? Let’s assume that such a business also sustains high pricing power (and hence profitability on the income statement) and a healthy rate of capital reinvestment. In such a case, the rate of growth in free cashflow […]
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