July 18, 2024

Stock Prices Always Follow Free Cash Flow Per Share Over Time

Authored By Louis Stevens

This morning, on X and in the LAS community, I shared a handful of charts that illustrated free cash flow per share alongside the share price of the company in question.

As the readers of this Briefs series know well, free cash flow per share is the basis of all equity value. There's nuance to this statement, but we will explore that in a moment.

Free cash flow per share represents the key element in fashioning an equity into a little bond whereby we understand the cash that we actually receive as owners of the equity; therefore, there's a true basis of value. After all, the whole point of this game is to receive cash distributions at some point in the future, or in the present to near future in the case of companies that pay dividends.

These ideas were succinctly communicated by Mr. Buffett in this short video clip (shared from specific timestamp; listen until 21:30).

"The cash flows are printed on the bond. The cash flows are not printed on a stock certificate. That's the job of an analyst." -Warren Buffett, Georgia Terry School of Business Lecture

"Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share." -Jeff Bezos, 2004 Amazon Shareholder Letter

While sharing the aforementioned charts, I was reminded that, in a sea of almost infinite data, with innumerable perspectives on this or that stock, and volumes of financial data associated with this or that stock, the very simplistic view of the growth of free cash flow per share alongside a share price is arguably the most concrete illustration of a company's truth and future share price trajectory.

It represents the concrete, indisputable, and bond-like realities, borrowing from Mr. Buffett's commentary above, for a given company.

It is akin to a compass held by a 16th century sailor who, while sailing untethered to any view of land, must identify his direction of travel.

With these ideas in mind, let's explore a handful of free cash flow per share charts together today. We will also discuss the above ideas with greater nuance in just a moment.

I'd like to start with Hims & Hers Health because it represents an instance in which free cash flow per share rose rapidly while the stock price languished.

Free Cash Flow Per Share Of Hims & Hers Health Soars And Share Price Eventually Caught Up

The title of this brief is "Stock prices always follow free cash flow per share over time" because often stocks do not immediately behave as the quantitative realities underlying their businesses demand.

"The market can stay irrational longer than you can stay solvent," so to speak (quoted related to the inefficiency of the market and shorting stocks. When you're long, you can just hold through the inefficiencies without fear your brokerage telling you to close your short position, granted you're also not using margin, in which case your brokerage may ask you to close your position or add funds to your account to ensure you're good for the loan).

Moreover, as I noted a moment ago, there's nuance to the idea that stock prices always follow free cash flow per share over time.

While free cash flow per share is an important driver of equity value, as the readers of this series know well, there are four key elements of equity value:

  1. Free cash flow per share
  2. The growth of free cash flow per share
  3. The durability of free cash flow per share
  4. Our next best alternative; specifically, in the world of equity investing, the risk free rate or yield that we can generate buying U.S. treasury bonds, such as the 2 year or 10 year

These are all elements necessary to fashion a stock into a bond in such a way that we can understand the concrete cash yield that we are likely to receive over time, thereby we can more concretely understand the value of the stock and its associated business in question.

That said, identifying those variables forces us to make assumptions, and assuming famously makes an ass out of you and me (ass out of u and me, assume. It's an American saying).

To this end, I do think that, while very simple in nature, a chart of free cash flow per share, alongside a company's share price, can be a profoundly useful tool in identifying the direction in which a stock will travel over time.

We should, of course, work to understand a given company's qualitative nature, via which we can insert values for the four points of equity value detailed above. This looks like identifying a company's competitive advantages. Does it have:

  • A brand moat?
  • A network effects moat?
  • An economies of scale moat?
  • A switching costs or embedding moat?
  • A regulatory capture moat?

Answering these provides insights into the third point of equity value, i.e., how durable, or protected to put it another way, the cash flows are.

Conducting total addressable market analysis alongside a moat analysis sheds light on point two. Additionally, understanding the nature of the business, using LAS' four foundational investment frameworks, can inform answers to both points two and three.

In short, while free cash flow per share is important in understanding the trajectory of a company's share price, if we zoom the microscope in a bit more, we find that there's just a few other elements that need be factored into the equation.

With that nuance out of the way, let's review a few more free cash flow per share charts to better appreciate this important correlation between stock price and free cash flow per share.

Amazon's Share Price Has Moved In Lockstep With Its Free Cash Flow Per Share Trajectory
Axon's Share Price Has Moved In Lockstep With Its Free Cash Flow Per Share Trajectory
Sea's Share Price Has Lagged The Trajectory Of Its Free Cash Flow Per Share Recently, Similar To Hims & Hers Health's Experience
Sea's Share Price Has Lagged The Trajectory Of Its Free Cash Flow Per Share Recently, Similar To Hims & Hers Health's Experience
Five Below's Share Price Has Moved In Lockstep With Its Free Cash Flow Per Share Trajectory

I included Five Below to illustrate that this correlation goes in both directions. If free cash flow per share dives, perhaps because a company does not have the competitive advantages it once had, or perhaps because it's run out of room for growth and struggles innovate new products to extend its growth runway, then the stock price will dive to. This is why it's important to employ the added analysis that I shared just above.

To close, free cash flow per share is a fantastic guide for determining where a share price will go over time, but it's not perfect. It's crude.

To more completely understand the nuance of an equity's value, we should employ our four points of equity value, a moat analysis, and LAS' four foundational investment frameworks, via which we perform the job of an analyst and investor more completely.

Disclosures:

L.A. Stevens has rated Sea Ltd. and Hims & Hers Health "buys."

L.A. Stevens has not rated Amazon, Snowflake, Axon, or Five Below.

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