Yesterday, I explained how adjusting a price/earnings (P/E) ratio for underlying earnings growth is helpful in ensuring that you don’t overpay for growth.

Especially for established companies.

However, I noted that when it comes to immature companies or those entering or emerging from distress, a different method was more appropriate.

It comes down to what is meant by “earnings”.

Let me explain…

Many assume that “earnings” means “profit”. In a legal or accounting sense, it does.

But that can be misleading when it comes to valuation.

Why? Because earnings, as an accounting term, can be heavily distorted by all manner of non-cash accounting items. Especially those that make a company appear profitable when it isn’t… or at least not sustainably so.

The list of non-cash accounting items is long. It includes things such as depreciation and amortisation, interest deductions, unpaid taxes or other accruing liabilities. It also includes unpaid receivables, inventory valuation adjustments, and so on.

When it comes to relatively immature companies, distressed companies or emerging from reorganisation, earnings might even be negative.

A price/earnings ratio, even if growth-adjusted, isn’t applicable in such instances.

Hence for these companies we shouldn’t rely on earnings or other accounting-distorted metrics at all.

Rather, we should focus on cold, hard cash. In particular, so-called free cash flow or FCF.

FCF is what it says it is: the cash a company generates from its operations, less whatever it uses for capital expenditures to maintain the existing capital stock of the company.

Maintenance is necessary for a company to remain a going concern. Hence why it is subtracted in the calculation of FCF.

What is left over is the “free” part of cash generated that can be put to whatever purpose, such as servicing or paying down debt.

Or paying out dividends to shareholders. Or the company can reinvest it in expanding existing operations or use it to acquire new assets and expand into new areas.

But the key thing about FCF is that it exists at all.

When a company is young or distressed and struggling towards sustainable profitability it’s in a risky position. It burns through whatever capital it has raised.

Shareholders may grow concerned about the possibility of future share dilution if cash generation is poor and capital is burning too quickly.

If there is any debt on the balance sheet, the ability to service it is vital. A company can only do that with cash.

The bank or other creditors don’t care if non-cash “earnings” are positive or appear to be growing. If FCF is poor and deteriorating, it has a higher risk of default and bankruptcy.

If that happens, it may wipe out shareholders altogether. Hence relying on non-cash earnings as a valuation metric can be not only misleading, but dangerously so.

Applying FCF in practice

Let’s take a look at two very different examples of applying FCF. First, let’s look at Rolls-Royce Holdings plc (RR). It got into trouble with creditors a few years back and had to reorganise and reschedule debt.

As the problems mounted, the P/E ratio soared (lower chart below). Foolish investors might have thought it was because the company’s growth prospects were improving.

But this was not the case. It was due entirely to collapsing earnings expectations.

Source: Koyfin

The company would soon enter into a reorganisation and debt rescheduling programme with its creditors. Following that, the P/E settled into a more normal range.

Today, it stands at over 30, reflecting the company’s strong growth prospects. In particular its defence-related operations.

Now, let’s look at P/FCF. As with the P/E ratio it soared (lower chart below). It showed that not only earnings but actual cash generation was collapsing. That the company would soon be unable to pay its creditors on schedule.

Source: Koyfin

Following the rescheduling, the P/FCF ratio settled into a more normal range and today stands at around 18.

The company is no longer distressed. But throughout all of the above, the metric you would have wanted to watch most closely was FCF, not earnings.

It would have given a much more accurate and timelier picture of what was really going on. Fortunately, the company has since succeeded in turning itself around.

Now, let’s look at something completely different: Glencore plc (GLEN), a mature materials company that decided to cut its dividend sharply last year.

Dividend cuts can be a sign of possible corporate distress. That is, a company concerned that, if it keeps paying so much cash to shareholders in dividends, it won’t have enough to safely continue operations. That includes any debt service requirements.

At the time, Glencore was trading at a modest P/E of about 10 (lower chart below).

Source: Koyfin

Since then, the share price has moved sideways overall, moving first up, then down, then up again more recently. The P/E ratio is now higher, however, at around 13.

That is, the market is pricing in a slightly faster pace of earnings growth for the future.

Those are hardly signs of corporate distress. Quite the opposite. And looking at the next chart, showing P/FCF (lower chart below), helps to explain why.

Source: Koyfin

Looking at the left side of the chart, we see the P/FCF ratio was extremely low prior to the dividend cut, at about 8. Glencore, in other words, was already hugely cash-generative at the time, relative to its valuation.

The ratio has risen since to over 10. The higher P/E and P/FCF ratios after the dividend-cut suggest that Glencore was probably paying out more cash than it should have been. The markets have rewarded the company with a higher valuation for its decision to reduce the dividend.

Glencore has stated repeatedly that it’s open to using cash for acquisitions. Having cut the dividend, it will have even more cash on hand.

The markets have since given Glencore the thumbs up that they would welcome sensible, targeted acquisitions.

Hence this was never a distressed story at all. Instead, it was a shift towards a more aggressive, acquisition-led, cash-funded growth strategy that the markets seem to like.

When looking at a mature company with fairly stable or predictable revenue growth, FCF is not particularly useful most of the time. But it’s a good place to look for signs of brewing trouble.

The thing to watch out for is if earnings and FCF begin to diverge. If earnings are growing and the share price is stable or rising, all might seem to be well.

But if FCF is trailing earnings and P/FCF rises, that’s a warning sign the share price could be vulnerable to a sharp correction lower.

On the other hand, a previously distressed company that has stabilised or is again growing its FCF and yet still trades at a low P/FCF ratio could be a candidate for strong outperformance in the future.

Until next time,

John Butler
Investment Director, Fortune & Freedom

Strange Days… and the Big Gain

Bill Bonner, writing from Baltimore, Maryland

An old Irish joke goes: “How do I get to Dublin?” The local replies, “Well, you don’t want to start from here. You can’t get there from here.”

We begin with where we are. USA Today:

US stocks end up, with S&P 500 at record. 

But the S&P is not the only thing hitting records. Fartcoin, Butthole coin, Microstrategy, FartStrategy, $Trump, $Melania, $Lorenzo… even dead men are launching new wealth defying cryptos. John McAfee, who committed suicide three years ago, on X last week:

“I’m back with AIntivirus. An AI version of myself,” @officialmcafee’s post reads.  “You didn’t think I would miss this cycle did you?”

Whatever else can be said about where we are… it’s a pretty strange place.

Our first priority is to avoid the Big Loss. If we can keep our wealth more or less intact, we can benefit from time, compounding, luck, our own wisdom… increasing (or decreasing!) with age, and occasionally, good research.

That brings us to our second priority. Going in the opposite direction from the Big Loss is the Big Gain. Today, we wonder where it is. We don’t think the Trump Team can get from where we are to where we want to go… but we don’t doubt that there’s money to be made somewhere.

To bring new readers – if there are any – up to speed, leaders don’t make as much difference as most people think. The path of events is determined by deeper historical forces – the ‘primary trend’ in markets… and in politics.

In democracies at least, the aspiring Caesar must connect to the soul of the masses… or he’ll be forever condemned to lead a more honest life.

This is not to say that he must obey the ‘will of the people’ once in office… but only that his rigging and conniving can’t be too far out of step with where The People think they want to go. These considerations usually give us the leaders we need – not to ‘do the right thing,’ but to carry out the mission given to them by fate.

This brief description of ‘historical determinism,’ of course, is not ‘true’ in any empirical way. It can’t be tested or proven. But it’s probably a good way to look at it. And it’s the best we can do… without having access to the mind of God.

Empires rise and fall. There are no exceptions. It doesn’t matter what people said… or thought. Or whether their leaders were good or bad. They could have polled the citizens of Rome in the 5th century. Most people might have answered, ‘yes, I’d like to keep the empire as it is.’ But so what? In 410, Rome was sacked. By 472, the western empire was history.

In 1980, gold was at its zenith… stocks at their nadir. A single ounce of gold could have paid for almost the entire 30 Dow stocks. The potential for a big gain in gold was slim; the risk of a big loss was obvious.

From a high over $800 an ounce, gold fell all the way to the ‘Brown Bottom’ in 1999. On May 7th of that year – with the price at $282.40 – Gordon Brown, Chancellor of the Exchequer (Sec. of Treasury), announced the sale of approximately half of Britain’s gold.

The timing couldn’t have been worse. After suffering the Big Loss, 1980-1999, with the price down 67%, Brown then locked in the loss by selling gold at its lowest price.

But if the Bank of England and other gold holders had already taken the Big Loss, we reasoned, there probably wasn’t much loss left to take. Instead, the action of the previous 19 years should be followed by an equal and opposite reaction over the next 19 years. A Big Gain, in other words. With the price of gold still under $300, and the Dow now selling for more than 40 ounces of gold, the Big Loss should now come to the stockholders, not the holders of gold.

That is what happened. Gold rose 10 times to today’s $2,770 price. Stocks went down; in gold terms, the Dow fell from over 40 ounces to today’s 16 ounces.

Historical determinism works for markets as well as politics. It didn’t matter who was president… or what investors thought… or said. The primary trend turned against gold in 1980… and against stocks in 1999.

And today?

When we look around today, it is clear today where the Big Loss is likely to come from. Once again, stocks are selling for record-high prices. Fortune:

Larry Summers warns bubbling asset prices are hitting levels of froth last seen prior to the financial crisis. In an interview with German business daily Handelsblatt, the former Treasury Secretary said bullish sentiment reminded him of the giddy days that preceded the 2008 financial crisis and the dotcom bubble at the turn of the century. 

Not only are equity prices near a top, strange non-equities are having a field day too. CNBC:

Greenlight Capital’s David Einhorn thinks speculative behavior in the current bull market has ascended to a level beyond common sense. “We have reached the ‘Fartcoin’ stage of the market cycle,” Einhorn wrote in an investor letter obtained by CNBC. “Other than trading and speculation, it serves no other obvious purpose and fulfills no need that is not served elsewhere.”

And where’s the Big Gain?

Tune in next week for more…

Regards,