In one sentence: Phil and Danielle compute the $13.4B price, then use Whole Foods' cash flow statement to show that free cash flow (about $800M) was much larger than earnings ($507M), and run a payback-time calculation to see why $42 was reasonable to both sides.
Key ideas
- From price per share to deal size. About 319.7M shares times $42 is roughly $13.4B (the press said $13.7B). Phil says to use the share count on the company's SEC filings, and he corrects himself from "13.9". [10:00–12:00]
- Phil's four steps still apply to any business. Capable of understanding, moat, trustworthy management, margin of safety, whether it's a stock, a franchise or the house across the street. "The jockey can take the horse places you don't want to go." [05:00–08:00]
- Loving a company has a psychological cost: anchoring. Danielle cried selling Whole Foods. Phil points to Kahneman's anchoring: once you've defended an investment you find it hard to re-evaluate when the facts change. The cure is to do the homework first and still re-check later. [12:00–22:00]
- Why Bezos wanted it (speculation). 444 stores plus Amazon Fresh would put about 70% of the US population within an hour of fresh-food delivery. Grocers ran about 2% margins, so an owner with deep pockets can cut prices and hurt them. Public grocers fell 8–15% on the news. [22:00–26:00]
- Earnings are partly fiction; cash isn't. Whole Foods' 2016 net income was $507M but cash from operations was $1,116M. Earnings include promises to pay and non-cash charges such as depreciation and amortisation. [26:00–31:00]
- Free cash flow = operating cash flow − capital expenditures. Phil: 1,116 − 323 (purchases of property and equipment) ≈ $800M, about 60% above net income. [31:00–38:00]
- Rental-house example. $20,000 of rent less $5,000 of costs leaves $15,000 of cash. A $10,000 depreciation deduction (a $200,000 building over 20 years) leaves $5,000 of taxable income. Net income is $5,000 but cash is $15,000, and the house probably isn't losing value. Danielle's fix: earnings is revenue minus expenses, not revenue. [33:00–38:00]
- Payback time. $13.4B against $800M of FCF growing 10% a year is repaid in just under 10 years. With the analysts' 6% growth it takes about 13 years. Phil says Buffett would like 6–8 years, but 10 is not crazy. [38:00–43:00]
- Free cash flow as a weapon. Phil argues Bezos can cut prices until Whole Foods' earnings go to zero while it still makes cash, so he has a weapon about twice what an earnings-based view suggests. [39:00–42:00]
- Two sides of the price. Mackey may see 13 years of payback at the current outlook as a good sale, while Bezos sees 10 with growth, so $42 is plausible for both. [41:00–43:00]
How it maps to RuleOne
- The screen's free cash flow and FCF / net income measures are this lesson. A company with FCF well above earnings is not automatically better. Check capex and whether the depreciation is real (a retailer still replaces equipment).
- Payback time (the price divided by growing FCF) is the thing to compute on a /stock/TICKER/ page. Phil's target is about 8 years.
- /holdings/ is where to see whether your attachment to a position is anchoring you.
Buffett, Munger and Graham links
- Buffett's "owner earnings" (Berkshire 1986 letter, appendix on goodwill) is the same idea: cash after the capex needed to stay in business.
- Buffett's EBITDA warning in the 2000 letter fits the depreciation point: depreciation is not "free".
- Kahneman, Thinking, Fast and Slow (anchoring); Munger's Poor Charlie's Almanack covers commitment and consistency bias.
Words to know
- Free cash flow (FCF): operating cash flow minus capital expenditures.
- Capital expenditures (capex): spending on property, equipment or stores to keep or grow the business.
- Depreciation and amortisation: non-cash charges that spread the cost of assets over their lives.
- Payback time: years of free cash flow needed to earn back the purchase price.
Try this
Open /stock/TICKER/ for a company you hold. From the cash flow statement note net income, operating cash flow and capex. Compute FCF and FCF as a percent of net income, and say whether the gap comes from depreciation or from something temporary.
Check yourself
- Why can free cash flow be larger than net income?
Answer
Non-cash charges such as depreciation reduce earnings but not cash. Capex is subtracted from operating cash flow to get FCF, so a business with low capex relative to depreciation shows FCF above earnings. - What is payback time?
Answer
The number of years of (growing) free cash flow it takes to recover what you paid for the whole business. - What is anchoring and why does it matter for a holding you love?
Answer
Having committed to and defended a view, you resist revising it. You may keep a company after its moat or value has changed.
Short quotes
"You can't spend earnings. What you can spend is cash flow." (Phil, ~28:30, auto-transcribed, trimmed)