“Henry Singleton has the best operating and capital deployment record in American business … if one took the 100 top business school graduates and made a composite of their triumphs, their record would not be as good as Singleton’s.”
—Warren Buffett, 1980
Teledyne: Henry Singleton’s Cash Flow Machine
This post is about earnings, cash flow and the search for the value created in a business during its lifetime. How should an investor measure the value being created in a business? Should the focus be on earnings, earning power, free cash flow, or maybe something else? Or is earning power a measure derived from both considering the earnings and free cash flows generated?
Excerpt below from chapter two—An Unconventional Conglomerateur: Henry Singleton and Teledyne—of The Outsiders (emphasis added).
Once the acquisition engine had slowed in 1969, Roberts and Singleton turned their attention to the company’s existing operations. In another departure from conventional wisdom, Singleton eschewed reported earnings, the key metric on Wall Street at the time, running his company instead to optimize free cash flow. He and his CFO, Jerry Jerome, devised a unique metric that they termed the Teledyne return, which by averaging cash flow and net income for each business unit, emphasized cash generation and became the basis for bonus compensation for all business unit general managers. As he once told Financial World magazine, “If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. Our accounting is set to maximize cash flow, not reported earnings.” Not a quote you’re likely to hear from the typical Wall Street–focused Fortune 500 CEO today.
Is Negative Free Cash Flow the Same as Zero Value Creation?
In the fourth edition of Financial Statement Analysis and Security Valuation the author Stephen H. Penman discusses the topic of free cash flow and concludes in the second paragraph that free cash flow is not a measure of value added. Then what is a measure of value added? The search goes on, but it sometimes feels like “The more you know, the more you know you don’t know.”
But, for what it’s worth, let’s see what Penman has to say about free cash flow and his take on free cash flow when it comes to valuing a business (emphasis added).
Free Cash Flow and Value Added
Why does DCF valuation not work in some cases? The short answer is that free cash flow does not measure value added from operations over a period. Cash flow from operations is value flowing into the firm from selling products but it is reduced by cash investment. If a firm invests more cash in operations than it takes in from operations, its free cash flow is negative. And even if investment is zero NPV or adds value, free cash flow is reduced, and so is its present value. Investment is treated as a “bad” rather than a “good.” Of course, the return to investments will come later in cash flow from operations, but the more investing the firm does for a longer period in the future, the longer the forecasting horizon has to be to capture these cash inflows. GE has continually found new investment opportunities so its investment has been greater than its cash inflow. Many growth firms—that generate a lot of value—have negative free cash flows. The exercises and cases at the end of the chapter give examples of two other very successful firms—Wal-Mart and Home Depot—with negative free cash flows.
Free cash flow is not really a concept about adding value in operations. It confuses investments (and the value they create) with the payoffs from investments, so it is partly an investment or a liquidation concept. A firm decreases its free cash flow by investing and increases it by liquidating or reducing its investments. But a firm is worth more if it invests profitably, not less. If an analyst forecasts low or negative free cash flow for the next few years, would we take this as a lack of success in operations? GE’s positive free cash flow in 2003 might have been seen as bad news because it resulted mostly from a decrease in investment. Indeed, Coke’s increasing cash flows in 2003 and 2004 in Exhibit 4.1 result partly from a decrease in investment. Decreasing investment means lower future cash flows, calling into question the 5% growth used in Coke’s continuing value calculation.
Free cash flow would be a measure of value from operations if cash receipts were matched in the same period with the cash investments that generated them. Then we would have value received less value surrendered to gain it. But in DCF analysis, cash receipts from investments are recognized in periods after the investment is made, and this can force us to forecast over long horizons to capture value. DCF analysis violates the matching principle (see Box 2.4 in Chapter 2).
A solution to the GE problem is to have a very long forecast horizon. But this offends the first criterion of practical analysis that we established in Chapter 3. See Box 4.3.
Another practical problem is that free cash flows are not what professionals forecast. Analysts usually forecast earnings, not free cash flow, probably because earnings, not free cash flow, are a measure of success in operations. To convert an analyst’s forecast to a valuation using DCF analysis, we have to convert the earnings forecast to a free cash forecast. This can be done but not without further analysis. Box 4.4 summarizes the advantages and disadvantages of DCF analysis.
Additional Reading: Henry Singleton Case Studies
- Teledyne and Dr. Henry Singleton, Case Study in Capital Allocation (CSInvesting.org)
- Slide Deck: A Case Study In Financial Brilliance Teledyne, Inc. Dr. Henry E. Singleton (Omega Advisors, Leon G. Cooperman)
- Video: A Case Study in Financial Brilliance: Dr. Henry E. Singleton of Teledyne Inc. (Omega Advisors, Leon G. Cooperman)
- Beating the market by buying back stock, Carol J. Loomis, Fortune