In one sentence: Phil explains free cash flow and how to test it against earnings, then compares an "equity bond" income strategy (buy 10–20 dividend payers for the yield) with the Rule #1 way: you still need to understand the business, and you should buy it at a good price so you collect both the cash and the appreciation.
Key ideas
- Free cash flow, again. Operating cash flow minus capital expenditures (the "purchase of property and equipment" line on the cash flow statement). It is what an owner could take home. [04:00–08:00]
- Test it against earnings, for ten years. Divide free cash flow by net income for each year and average. Around 100% or more is ideal, since it means the earnings are real cash. Apple averaged about 120%. [07:00–14:30]
- Why cash can exceed earnings. Accrual accounting records income and expenses before cash moves, and depreciation is a non-cash expense that is added back. If actual capital spending is below depreciation, free cash flow can exceed net income. Phil calls net earnings partly an accounting fiction. If unsure, assume depreciation approximates what must be replaced. [09:00–12:00]
- Capital intensity decides the ratio. A car maker must keep retooling, which soaks up cash. A brand or franchise business like Chipotle needs little, so more passes through. Mature, well-positioned businesses (IBM, Apple) throw off lots of cash. [12:00–15:00]
- Free-cash-flow yield and the equity bond. At about $150 a share with about $15 of free cash flow per share, IBM's yield on that price is about 10%. Treating it as a bond you hold, a dividend of about $5 would be about 3.3%, which beat Treasuries at the time. Phil says IBM paid out roughly a third in dividends and two thirds in buybacks. [15:00–19:00]
- The income strategy. Some investors skip valuation and buy 10–20 solid dividend payers, judging them by yield on the price paid. You still need to understand the business and its durability, and "price" shows up as the yield you receive. [19:00–22:00]
- Why Phil dislikes it in this market. Many people are chasing yield and bidding prices far above value. If interest rates normalise, the yield investors demand rises. Phil's worked example: if Treasuries move from 2% to 4%, the IBM yield must roughly double to about 6.6%. With the $5 dividend unchanged, the price would have to fall to about $75. [22:00–29:00]
- Income investors still get paid. The holder still gets the $5, so the strategy is fine for the very wealthy who only need income. Danielle's challenge is that they leave money on the table, and Phil agrees at least for people starting small. [28:30–30:30]
- The better combination. Do the work: buy understood businesses with a moat and good capital allocators, on sale, so that you get cash flow plus appreciation. If the price falls to $75 you aren't worried, because you expect it to be worth far more in ten years. Phil cites a lesson from GM, where people bought for the dividend and the business later failed. [30:00–34:00]
- Next. Buybacks, which Phil says matter for the yield but are often misunderstood, are postponed twice, first for the JJ Virgin interview. [34:00–35:00]
How it maps to RuleOne
- The valuation page's free-cash-flow ratio and payback figures automate the ten-year test. A ratio persistently below 100% is a prompt to read the cash flow statement and ask what the company has to spend to stay in business.
- The payback view on the stock page is the equity-bond idea: how many years of cash flow repay the price.
- Rule #1 values the business on owner cash flow. Dividends are only one way the cash is paid out.
Buffett, Munger and Graham links
- Owner earnings: Buffett's 1986 Berkshire letter defines them as earnings plus depreciation minus the capital spending needed to keep the business competitive.
- Dividends versus retained earnings and capital allocation: Buffett's 1984 and 2012 letters on when a company should pay out and when to retain.
- Graham's The Intelligent Investor (chapter 19) covers dividend policy for the defensive investor, with the rest of the margin-of-safety framework.
Words to know
- Free cash flow: operating cash flow minus capital expenditures.
- Capital expenditures (PP&E purchases): spending on long-lived assets, shown on the cash flow statement.
- Dividend yield: annual dividend divided by the price you paid.
- Equity bond: owning a business as if it were a bond, judged by the cash it pays you on your price.
Try this
Open the valuation section of a company on /stock/TICKER/ and find its free-cash-flow ratio for the last ten years. Note any years when it fell below 100% and look up what the company spent on capital expenditures that year.
Check yourself
- How can free cash flow exceed net income?
Answer
Net income includes non-cash expenses such as depreciation. If actual capital spending is lower than depreciation, more cash is left than the earnings number suggests. - Why might a dividend-yield strategy hurt when interest rates rise?
Answer
Investors will want a higher yield, so with an unchanged dividend the price must fall to deliver it. IBM at a 3.3% yield would have to drop from $150 to about $75 to yield 6.6%. - What does Phil add to the income strategy?
Answer
Do the business and price analysis too, so you collect the cash flow and the appreciation, and don't panic if the price drops.
Short quotes
"Net earnings of a company are a fiction." (Phil, ~09:00, auto-transcribed)