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It’s well said by Mr. Wonderful of SHARK TANK show that “It’s all about FREE CASH” , irony of this fact is that a business that’s generating a healthy FREE CASH flow and sending it straight to its shareholders might be less valuable than one that’s generating zero or very little FREE CASH flow. This statement might seem contrary to the most fundamental rule of business which is to generate CASH. Following example clarifies our theory.
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EXAMPLE : Jimmy and Ralph each own their own Floral retail shop. Jimmy is very conservative, he plans to spend a very limited amount on advertising. His sales for the year are $1million and he generates a healthy free cash flow of $300,000. Ralph on the other hand is enterprising and focused on long term growth, he optimizes his advertising budget to increase his net sales. His sales first year are $1million , but free cash flow is just $50,000. In the next 5 years Jimmy continues to generate $1 million in sales and $300,000 in Free cash flow thus generating $1.5 million of free cash in 5 years. Ralph on the other hand just generates $50,000 free cash for the first 4 years, but his sales double every year , $2 million in Year-2 , $4million in Year-3 , $8 million in Year-4 and $16 million in year-5. In fifth year Ralph realizes that he has reached the optimum growth and thus cuts back on advertising, his free cash flow for that year shoots up to $2 million. Thus Ralph generates $2.2 million of free cash in 5 years compared to $1.5 million of Jimmy, plus Ralph has increased his earning power to generate $2 million of free cash every year as compared to just $300,000 for Jimmy. This brings us to a very important concept called Return on invested capital (ROIC). Ralph’s business is more valuable than Jimmy’s (even though in short term Ralph was generating less free cash) because whatever free cash he was forgoing as advertising expense, he was able to recoup all in the fifth year and plus had increased his earning power for the future.Its important to note that capital spent on Advertising is expensed right away, but in reality it acted as a capital expenditure , because it has increased the earning power of the business If you have any doubts on this concept then please e-mail me : valuationtrg at gmail.com |
