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How to Estimate Future Free Cash Flow Growth for a Mature Cash Cow

When it comes to projecting or estimating future free cash flow growth, there isn’t a strict science behind it, other than commonly taught methods involving ROE and retention ratio, for example.

While using traditional methods to estimate future free cash flow growth can be helpful in getting a ballpark projection, there are many factors which can cause these estimates to become inaccurate.

First, let’s examine some of the most common and useful ways to numerically estimate future free cash flow growth:

  • ROE and Retention ratio
  • ROIC and Investment rate
  • Historical growth
  • Relative (essentially matching competitor’s historical growth)

I highly recommend that you give yourself an in-depth education on each of these methods of free cash flow growth estimation, with the articles linked above that we’ve previously covered on the site.

As a very superficial summary, here’s the formulas for each of the main methods:

  • ROE and Retention ratio
    • Estimated growth rate = ROE x Retention ratio
    • Where, retention ratio = percentage of earnings not distributed by dividends and share repurchases
  • ROIC and Investment rate
    • Estimated growth rate = ROIC x Investment rate
    • Where, investment rate = percentage of free cash flow not distributed by dividends and share repurchases
  • Historical growth
    • Examining financial statements and recording the growth in FCF/ share or EPS over a selected time period
  • Relative to competitors’ growth
    • Same process as historical growth, but measuring competitors’ financial statements

You’ll notice that each of these factors rely on historical data, which makes sense because historical data is the only reliable picture we can paint about a company’s performance (unless you have a crystal ball).

But, a blind use of this data to estimate future free cash flow growth can be detrimental to an investor’s results, because there are many other factors that can change the course of a business’s ability to create profits.

These can include:

  • New competitors entering high margin markets and reducing future margins
  • Current or new competitors creating a more valuable product or service
  • Industry consolidation creating stronger competitors
  • Changes in consumer preferences and behaviors changing demand or profitability
  • Changes in the macroeconomic picture, or regulation, or a myriad of other factors leading to an industry becoming less (or more) profitable, having a higher (or lower) growth in revenues potential, etc

That’s not to say that investors are hopeless to making intelligent investment decisions, or that we have to spend thousands of hours on every investment idea to think of every possible factor in the future (even Buffett never spent this much time on each idea, it’s mathematically impossible).

But that is to say that we need to make adjustments to our valuation models.

We can do this by either providing a higher margin of safety when outside factors seem to be evidently pressuring future free cash flow growth, and/or leaving a buffer or pessimistic view on our projected FCF growth rate compared to historical figures (this can go the other way too, where we can intelligently become more optimistic, though this should be a much more sparsely used technique).

Let’s take one historical example of a factor which influenced free cash flow growth, but on the positive side. And then we’ll look at a real life example.

Why Not All Free Cash Flow Growth is Created Equal

Since Buffett is really the king of free cash flow (what he calls owner’s earnings), let’s break down the types of businesses he likes to invest in.

Obviously he likes the businesses with a superior competitive moat and great growth—like Coca Cola, American Express, and GEICO.

But he’s also quite happy to invest in cash flow cows, businesses that aren’t necessarily the best or the fastest growing but require very little capital to spit out high amounts of free cash flow—See’s Candies and Dairy Queen just being a few examples.

A company like See’s Candies doesn’t need to invest heavily in new technology to stay on the cutting edge, and doesn’t really need to spend much on marketing in order to sustain demand, since their brand name is so strong.

Instead, See’s Candies spits out great free cash year after year as customers consume their chocolates for the holidays and Valentine’s Day, and Buffett uses that free cash flow to invest in other businesses.

Of course, See’s Candies probably had to reinvest heavily in its own business at the start in order to establish efficient manufacturing, build the brand name, and create the desired distribution channels.

But at a certain point the company felt like it grew enough, and then funneled those profits back to its owners rather than to expand continuously. This is evident by the fact that See’s Candies has historically been a West Coast brand, and has a muted mall presence around the country.

Rather than battle it out for global supremacy, See’s happily sold to Buffett, who has happily let See’s stay in their niche while he re-allocates those profits elsewhere.

It’s that inflection point where I want to focus today.

At a certain point, a company has to make a decision whether to heavily reinvest free cash flows back into the business to continue to aggressively grow…

Or, dial down the free cash flow reinvestment and continually return much of that cash back to shareholders (these days, it’s more aggressively done through share repurchases rather than dividends).

Another option is to use that free cash flow to make a bolt-on acquisition(s) in an adjacent industry, wherein the company will simply redirect future free cash flows into that business segment to aggressively grow in that space—but that’s not the situation I want to examine.

I want to see if we can find the See’s Candies type of businesses.

Those which can provide free cash flow growth through the less traditional way of not retaining earnings/ FCF, but rather distributing it back to owners (which can create free cash flow growth per share through heavy share buybacks).

I believe we can do this by looking at financial statements, identifying the inflection point, and then intelligently determining whether the company is going down that direction or not.

Industry Maturation and Free Cash Flow

Really at the end of the day, it all comes down to industry maturation.

In a great piece about life cycles of an industry, IFB Equity contributor Cameron Smith revealed the 5 major stages of an industry’s life, which can be applied to individual businesses as well:

  1. EMBRYONIC Stage
  2. GROWTH Stage
  3. SHAKEOUT Stage
  4. MATURE Stage
  5. DECLINE Stage

Essentially, there is exponential growth for a market until the SHAKEOUT stage, at which point demand for the industry’s products and services begins to slow and stops its exponential trend.

Valuations start to compress back to the more rational values here, and the difference between the strong and the weak competitors finally starts to become evident.

As this evolves into the MATURITY stage, which as Cameron states is hopefully the longest and most fruitful for companies and investors, the efficiency of an industry really hits the inflection point and businesses have a fundamental decision.

Should they (1) stay a free cash flow cow, (2) find attractive opportunities in a new market, or (3) destroy shareholder value?

In situation 2, if the company can intelligently find a great new market to funnel free cash into for maintaining its historical growth (and ROE and ROIC), then those free cash flow growth formulas work well in projecting that company’s future.

In situation 3, which can be a by-product of a failure of situation 2, traditional free cash flow growth projections won’t work so well in identifying the company’s true performance, as new capital is invested at rates which return less in future growth than when the industry was younger.

Let’s dive into a company’s financial statements to try and identify situation 1, where a company decides to just stay a cash cow.

Matured Industry Example: Shutterstock

I want to examine a small business in a small niche market, Shutterstock ($SSTK). This is a company that provides paid stock photos, which businesses and consumers use to remain copyright complaint on blog posts, videos, and other commercial use or personal use material.

This industry is interesting because most of the players work on an almost “Uber” model for stock photos.

Basically, contractors can submit their own photographs, and businesses and consumers purchase the rights to these photographs, with a website like Shutterstock simply providing the marketplace for it.

More on that in a bit, let’s see why I identified this company as possibly at an inflection point for FCF.

Taking the company’s latest 10-k filed in February 2020, their cash flow statement reports the following:

Notice the two trends here. We have Capital Expenditures that are significantly lower than Depreciation and Amortization in 2019, and a rapidly declining Capital Expenditures from 2017 to 2019.

Cash from operating activities are basically flat from 2017 through 2019, but a rough estimate of FCF (CFFO minus Capex) shows a free cash flow growth rate of 27% in 2018 and 13.7% in 2019.

Note that shares outstanding has been flat in this same time period, so we can substitute FCF for FCF/share.

The next question becomes, what has the company done with this unlocked FCF?

There was a special dividend in 2018 of $104m, so that looks like the big capital allocation over the last 3 years.

Since historical Depreciation and Amortization has been between $35m and $49m, and Capex has decreased from $55m to $34.9m to $26m, that’s an extra $40m or so in free cash flow which the company unlocked simply by lowering their capital expenditures (evolving to a cash cow).

This begs another question:

  1. Is management dropping the ball by not getting aggressive to reinvest in future growth?
  2. Or, has management identified that their industry is in the MATURITY stage and will stay there?

That takes us back to evaluating the industry itself and where it is in its life cycle, which is where an investor’s circle of competence comes in.

I have a bit of a circle of competence in the general internet/ website business industry, and so I can hazard a guess.

Using proprietary research, I’ve identified the following as the biggest players in the stock photo industry:

  • Shutterstock.com
  • Pixabay.com
  • Unsplash.com
  • Pexels.com
  • 123rf.com
  • Gettyimages.com
  • Istockphoto.com

There’s some consolidation within this industry already, where pixabay and pexels are owned by Canva Ltd and gettyimages and istockphoto are owned by Getty Images Inc.

Both of these companies are private, and the remaining websites are also privately owned, which makes researching this industry difficult. $SSTK is the only publicly traded company here.

While it gives us no financial information to evaluate, it does tell us the relative size of the industry itself.

It’s small.

And again, with my proprietary research I’m able to identify that Shutterstock’s website is the unquestioned leader in its space, and there hasn’t been much in the way of growth (in visits) lately.

So the company has done what a company does when its end market is saturated, increase the average revenue per customer (sound familiar to Facebook and Netflix?). Also, as we saw in the financials, it has dialed down its capex.

Estimating the Future Free Cash Flow Growth of a Maturing Cash Cow

Let’s gather what we know and can reasonably assume.

We know that competitors will grow and attempt to steal market share.

  • How Shutterstock handles this threat depends on its competitive advantage (or lack of).

We know that the company will see growth from inflation and the growth of the market without doing anything, if it maintains its market share.

  • Companies will always need copyright compliant materials (as long as America protects intellectual property)
  • We know that the number of U.S. businesses will grow every year (I showed that historically this number has been around 1.5%)
  • We know that as inflation rises, so do most products and services (as long as they are essential, and competitors raise prices in lock-step) <– KEY assumption, by the way

The market looks small enough to not make a drop in the bucket for most big companies.

  • $650m in revenue for our leader SSTK
  • Industry with mostly private companies should make it hard for an outsider to aggressively acquire a large majority of this market

The industry is commodity-like. Major disruption is unlikely.

  • Outside of dramatically lowering prices, and/or making a massive push in marketing spend, stealing considerable market share appears difficult
  • Companies still need stock photos and can shop around willingly
  • Unsplash.com is trying the free model but its website’s performance hasn’t been trending in a good direction lately

With that all said, let’s come up with a free cash flow growth estimate.

Looking at the company’s latest 10-q filed October 2020, the company has spent $20m on Capital Expenditures through the first 9 months of the year, which compares with the almost $19m spent in the first 9 months of 2019.

So, it appears that we might’ve found the matured (annual) maintenance capex for this cash cow, the same ~$25m spent for capex in 2019.

Noting that revenue growth for the company over the last 2 years has been 4% and 11% respectively, and the CFFO (cash from operating activities) has been flat due mainly to extraneous transactions like changes in working capital and taxes and a divesture, I think a revenue growth estimate for the future could fall in the 4%-6%.

Let’s say that 2%- 3% comes from growth of the number of businesses and 2%- 3% from inflation.

This should flow smoothly down to free cash flow since we haven’t identified any crippling risk factors to those margins.

There could be some margin improvements here or there, but in general we’re at a matured industry stage and to be conservative I won’t add those to a free cash flow growth estimate.

Estimating Cash Flows and Growth in Cash Flows, and a Valuation

Finally, we have a new, “matured” free cash flow level where we can assume that maintenance capex should stay around $25m per year and the growth in CFFO will flow down to free cash flow growth.

In order words, the growth in FCF/share from the company reaching its cash cow stage has already been baked in (2019).

This determines that I would use 2019’s free cash flow estimate for a DCF valuation rather than a 3 year average or some other combination of multi-year averages.

Using the company’s historical WACC of 8%- 13%, I assume the following inputs:

  • FCF/share = $2.15
  • Discount rate = 9%
  • FCF/share growth rate = 5%

This brings me to a fair value for SSTK at $29.14.

Using a discount rate of 6% to assume lowered future cost of capital due to ultra-low interest rates puts fair value at $38.05— about where the company traded before the pandemic in March of this year.

With FCF/share rising up to roughly $2.73 for the TTM (trailing twelve months), investors have bid the stock up to $68.91 which assumes a 9.92% growth in FCF/ share from here.

Investor Takeaway

I hope that helps provide clarity on projecting future free cash flow growth for a company in a matured industry.

There’s definitely potential of finding gems with this approach, where the substantial increase to free cash flows from a transition to maintenance capex at an inflection point of the business has not been baked into estimates yet.

For ideas on when that could happen, I recommend reading IFB Equity contributor Dave Ahern’s article on calculating maintenance capex through a few formulas. Or, you could additionally find maintenance capex from a company’s 10-k if they make the distinction explicit.

Either way, it comes back to Warren Buffett’s owner’s earnings, and perhaps provides great clarity on why his free cash flow estimates are different than the traditional definition—where he’s dividing capex into maintenance capex and growth capex.

By valuing companies on their probable maintenance capex rather than total capex, you get to participate in the company’s substantial free cash flow growth once they hit the inflection point of reducing total capex spend.

A fantastic unlock of value, for both the company and the investor, as long as the industry conditions are right.