What drives free cash flows

...and how to use this understanding to pick winning stocks

- SAURABH MUKHERJEA

The valuation of any business is the net present value of all expected free cash flows in future. As a result, for every business, an investor needs to build their expectation of the quantum of growth and the longevity of growth in free cash flows. This is a universal concept that applies to every business. However, what is not common across businesses is the primary driver of free cash flows (which particularly affects the quantum of growth in free cash flows). Consider the following examples.

Type 1 Book value as the primary driver of free cash flows: Let's assume that there is a business which has a unique manufacturing process in a factory. The factory produces a product which meets an essential demand of a large customer base. Furthermore, let's assume that no competitor can produce a substitute product to meet this customer demand. As the business reinvests capital to expand its manufacturing capacity (plant and machinery), it delivers growth in free cash flows. To invest in such a business, investors must focus on growth in its asset base as the primary driver of its moat and hence free cash flows in the long term. Until half a century ago, investment in many great businesses was carried out on this basis (when the P/B multiple was a commonly followed metric).