Getting the right trade-off between quality, growth and price

Let’s say that you are given the option of buying one of the two companies shown below. Leaving aside the all-important issue of price just for the moment, which one would you prefer to own? 

Looking at a few key performance metrics, ABC looks to be a very profitable and high-quality business and perhaps a more attractive option than XYZ. However, both businesses produce £100m of free cash flow (FCF) per year despite ABC making more money out of each £1 of revenue and capital invested. 

What would you think if you were then told that ABC had very limited future growth prospects and was unlikely to increase its free cash flows in the future? XYZ on the other hand has lots of potential projects to invest in at the same rate of return it is earning now and is expected to keep on growing its free cash flows. 

This key bit of information totally changes the investment decision-making process. If XYZ can produce more free cash flow over its future life than ABC it will be a more valuable business. This simple example neatly illustrates one of the problems facing investors right now: Having high profit margins and a high return on capital employed (ROCE) is all well and good, but if the company cannot grow its revenues, profits and its free cash flows then its shares are unlikely to reward you – unless of course you can buy them for a very attractive valuation. As we shall see, the trade-off between valuation and growth is very important. Overpaying in anticipation of growth that doesn’t materialise is one of the biggest reasons for investors losing money in shares. 

The whole point of investing in high-quality businesses is to utilise the power of compounding. If a company with high profit margins and high ROCE can keep on selling more products and services at high returns then it will become more valuable over time at a faster rate than a business with lower returns.  

It's exactly the same process as putting more money into a high-interest savings account. An account with a high interest rate will compound into a bigger sum of money over time than one with a lower interest rate. But if a company with a high interest rate – a high ROCE – runs out of opportunities to grow its business it becomes more difficult for it to increase the value of its business. 

Company lifecycles – the trade-off between growth and valuation 

Many businesses go through a lifecycle. They grow very quickly at first and then growth slows down as the business matures or new competitors arrive. Despite being extremely profitable in terms of profit margins and ROCE, an absence of meaningful revenue and profit growth can lead to disappointing future investment returns for shareholders if shares are bought at the wrong time and the wrong price. 

During the growth phase, it is not unreasonable or unusual to see a company’s shares attract a very high valuation of its profits or free cash flows. As the business matures and it finds it harder to grow, the valuation of its shares should come down.  

If we are valuing shares on the basis of free cash flow – a lumpier but arguably more truthful measure than profits – then a high valuation in the growth phase will reflect the anticipation of growth and possibly the fact that free cash flows are suppressed by heavy investment in growth projects. When the business matures and rates of growth slow down it should produce more free cash flow – as investment is scaled back – which helps bring down the price to free cash flow multiple or increase the free cash flow yield of the shares. 

This may not be happening with the shares of some high-quality businesses right now. In some cases, the growth rate of profits and free cash flows has slowed or stopped, but the valuation of the shares remains high as indicated by low free cash flow yields. There is a disconnect between business reality and the expectations of stock market investors. 

James Halstead (JHD), a manufacturer and distributor of high-quality flooring products, could be a case in point. It is an extremely profitable and consistent business with profit margins of nearly 20 per cent and ROCE of 30 per cent. Over the past five years, its profits growth has slowed and its free cash flow has declined. 

It remains an outstanding business, but its share price has fallen back from its peak seen in 2017 and appears to be stuck in something of a rut. Yet the valuation of its shares arguably remains quite expensive.  

At the time of writing, the share price of 395p offers a trailing free cash flow yield (based on last year’s free cash flow per share) of 3.1 per cent. Unless James Halstead’s free cash flow per share can grow significantly over the next few years, it is quite difficult to argue that its shares are attractively valued – growth matters. 

Diageo (DGE) is an example of a larger business that has been able to grow its revenues, profits and free cash flows over the past five years while maintaining high profit margins and a respectable ROCE. 

Its shares also command a fairly high valuation at the time of writing. At 2,673p, they offer a trailing free cash flow yield of 3.6 per cent. The key question for investors to ask here is: How does a company that is already quite big get bigger and more valuable? 

This is an issue facing a lot of high-quality, large-capitalisation stocks, particularly in the US. The table shows the top 20 companies in the S&P 500 index ranked by ROCE with profit margins of more than 15 per cent. It also shows their trailing free cash flow yield. 

Many of the shares of these companies trade on high valuations – low free cash flow yields. When interest rates or yields on US government bonds are low it is easier for investors to justify lower yields – or higher valuations – on shares. This has been becoming more difficult to do as the yield on US treasuries has been increasing. 

Since bottoming in the middle of 2016, the yield on 10-year US treasuries has more than doubled and is rising. The current yield is 3.26 per cent, which is higher or not much less than the free cash flow yields on many high-quality US stocks.  

The main reason for the pullback in stock prices of these shares in recent weeks is because investors have been questioning whether the gap between the free cash flow yield and the treasury yield is big enough? After all, why take the risk of owning expensive shares when you can get 3.26 per cent lending money to the US government? There are also concerns as to whether current expectations for growth in profits and free cash flows are achievable. 

10-year government bond yields in the UK are lower – currently 1.54 per cent – and still held down by quantitative easing. Even so, many high-quality companies in the UK trade on low free cash flow yields. 

The reason to own these expensive, high quality shares is because there is potential for the companies behind them to keep on growing their free cash flows. But can they grow them enough and quickly enough to justify their current share prices? I’ll come back to this at the end of the article. 

The right type of growth 

Once you think you have identified a high-quality business, it is important to ask yourself whether it is capable of growing its profits and free cash flows in the future. What’s more important is to ask whether this growth can be achieved without reducing profit margins or ROCE too much. 

The best source of growth comes from selling more goods and services from a company’s existing business. This is often referred to as organic growth and comes from selling existing products into a growing market and/or launching new products or services. This type of growth is most powerful when it does not require lots of extra capital investment in property, plant, machinery or intangible assets. 

A company can also grow organically by spending money on new assets such as factories, distribution or new stores. This tends not to create as much additional value in a business as growing from existing assets, but is positive if the money spent earns a high ROCE (15 per cent or more). It’s a good strategy to identify businesses with significant reinvestment potential if you can. In other words, does a company have lots of scope to reinvest its cash flows in new projects in order to grow cash flows in the future? 

The least desirable source of growth comes from buying it. Mergers and acquisitions can lead to a big boost in profits and free cash flows from combining businesses and cutting costs. The problem is that any boost tends to be temporary. Buying companies can be a way of companies disguising weak growth or shrinking profits in its existing businesses. You need to be wary of companies that are serial acquirers of increasing size. Sooner or later, the buying opportunities and cost savings run out – often with catastrophic results. 

Another thing to watch out for, especially when looking at a company’s free cash flow is for signs of free cash flow manipulation. This can come from slashing investment (capex) or squeezing working capital. This can provide a temporary boost to free cash flow, but is not usually a sign of improving business performance. 

How much to pay for high-quality shares? 

As with many things in investing, this is a matter of opinion and debate. I would make the case based on an investor wanting some security from seriously overpaying for a high-quality, cash-generative business to look for a free cash flow yield of at least 5 per cent in five years or fewer. It's up to you to decide whether you want a higher or lower yield and in what time frame. Obviously, the higher the potential free cash flow yield on your buying price, the better. 

What is clear is that growth in free cash flow can justify what can be seen as a very high valuation – low free cash flow yield – when buying a share in the first place. Admittedly, hindsight is a wonderful benefit here. 

Source: SharePad. Capital IQ 

Returning to the collection of UK shares from earlier, I’ve looked at the free cash flow per share and free cash flow yields that were on offer to someone buying the shares five years ago. I’ve then looked at the current levels of free cash flow and compared that with the share price five years ago to get a free cash yield on cost. Finally, I’ve listed the current free cash flow yields at the current share price at the time of writing. 

What we can see is that Fevertree (FEVR), Games Workshop (GAW), Craneware (CRW), Bioventix (BVXP) and Tristel (TSTL) have delivered very high free cash flow yields on the price paid for their shares five years ago. The free cash flow yields of Fevertree, Bioventix and Tristel would probably have been considered to have been expensive back then, but their free cash flow growth has more than justified the price paid. 

Going forward, it is clear that some companies are going to have to see rapid growth in free cash flows over five years to achieve a 5 per cent yield on cost at the current share price. Others look to have less demanding growth challenges. However, just because a low growth rate is required it doesn’t mean that it will be achieved as a business may not grow its free cash flow at all. 

You can easily work out the free cash flow per share needed by multiplying the current share price by 5 per cent or your target yield. Compare this number with the last reported annual free cash flow per share to work out the growth needed. You can also work out the annualised growth rate required on a calculator or a spreadsheet.