What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
Virus4762
Posts: 100
Joined: Fri Jul 13, 2012 10:53 am

What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Virus4762 » Sat Jul 13, 2019 12:56 am

For the past few months, I’ve been checking out many companies in the utilities sector and one thing I’ve noticed is that many of these companies have capital expenditures so great that they often exceed the company’s operating cash flow for the year (i.e. the company has negative free cash flow). Take Xcel Energy for instance: https://financials.morningstar.com/rati ... atform=sal. One could argue that, if the company decreased capex, it could achieve a positive free cash flow, but doing so would obviously destroy the company’s future growth. If the only way a company can stay relevant is by keeping free cash flows negative, does the company really have any value? Obviously, it must have value because many of these companies have a market cap of 10s of billions of dollars but where does that value come from? How would you even go about valuing a company with almost entirely negative free cash flows (and that will sporadically and rarely have positive free cash flows in the future)?

Thanks.

Valuethinker
Posts: 38433
Joined: Fri May 11, 2007 11:07 am

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Valuethinker » Sat Jul 13, 2019 1:10 am

Virus4762 wrote:
Sat Jul 13, 2019 12:56 am
For the past few months, I’ve been checking out many companies in the utilities sector and one thing I’ve noticed is that many of these companies have capital expenditures so great that they often exceed the company’s operating cash flow for the year (i.e. the company has negative free cash flow). Take Xcel Energy for instance: https://financials.morningstar.com/rati ... atform=sal. One could argue that, if the company decreased capex, it could achieve a positive free cash flow, but doing so would obviously destroy the company’s future growth. If the only way a company can stay relevant is by keeping free cash flows negative, does the company really have any value? Obviously, it must have value because many of these companies have a market cap of 10s of billions of dollars but where does that value come from? How would you even go about valuing a company with almost entirely negative free cash flows (and that will sporadically and rarely have positive free cash flows in the future)?

Thanks.
Take a look at the fracking sector. Many of those companies have generated no free cash flow in aggregate over time.

A similar dynamic applies to Tesla or many high growth companies like Uber.

Setting aside whether the value of these companies *should* be this high, it is worth remembering we are living in a world of negative interest rates, estimated 13 trillion dollars of assets guaranteeing a negative return out there. German government bonds in particular. In that case the market is not irrational to offer historically low borrowing rates (or very high equity valuations) to quite risky companies.

Biotech companies, many tech companies are good examples of cash flow negative businesses that can achieve very high future free cash flows for shareholders.

So in the Discounted Cash Flow model you have annual cash flows (which can be negative), timing of cash flows (positive can be in the future not now; for a company operating in high growth markets it is rational to chase growth over immediate returns).

We have argued above that discount rates on future cash flows are low due to macroeconomic conditions. So time matters less, returns in the future are worth more.

So there is your answer. The management of the company is making bets on future profits by making investments now. That leads to negative free cash flow now, which can be financed, and may lead to higher free cash flows in the future.

Topic Author
Virus4762
Posts: 100
Joined: Fri Jul 13, 2012 10:53 am

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Virus4762 » Sat Jul 13, 2019 1:20 am

Valuethinker wrote:
Sat Jul 13, 2019 1:10 am
Virus4762 wrote:
Sat Jul 13, 2019 12:56 am
For the past few months, I’ve been checking out many companies in the utilities sector and one thing I’ve noticed is that many of these companies have capital expenditures so great that they often exceed the company’s operating cash flow for the year (i.e. the company has negative free cash flow). Take Xcel Energy for instance: https://financials.morningstar.com/rati ... atform=sal. One could argue that, if the company decreased capex, it could achieve a positive free cash flow, but doing so would obviously destroy the company’s future growth. If the only way a company can stay relevant is by keeping free cash flows negative, does the company really have any value? Obviously, it must have value because many of these companies have a market cap of 10s of billions of dollars but where does that value come from? How would you even go about valuing a company with almost entirely negative free cash flows (and that will sporadically and rarely have positive free cash flows in the future)?

Thanks.
Take a look at the fracking sector. Many of those companies have generated no free cash flow in aggregate over time.

A similar dynamic applies to Tesla or many high growth companies like Uber.

Setting aside whether the value of these companies *should* be this high, it is worth remembering we are living in a world of negative interest rates, estimated 13 trillion dollars of assets guaranteeing a negative return out there. German government bonds in particular. In that case the market is not irrational to offer historically low borrowing rates (or very high equity valuations) to quite risky companies.

Biotech companies, many tech companies are good examples of cash flow negative businesses that can achieve very high future free cash flows for shareholders.

So in the Discounted Cash Flow model you have annual cash flows (which can be negative), timing of cash flows (positive can be in the future not now; for a company operating in high growth markets it is rational to chase growth over immediate returns).

We have argued above that discount rates on future cash flows are low due to macroeconomic conditions. So time matters less, returns in the future are worth more.

So there is your answer. The management of the company is making bets on future profits by making investments now. That leads to negative free cash flow now, which can be financed, and may lead to higher free cash flows in the future.

Really? A $30 billion company that's been generating negative free cash flows for 10+ years and still has almost no growth rate is expected to return positive free cash flows in the future?


I don't understand why someone would invest in companies like this when the are so many companies out there that are generating positive free cash flows with 20%+ YoY growth rates (and whose multiples aren't that much higher than companies like this).

Iridium
Posts: 486
Joined: Thu May 19, 2016 10:49 am

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Iridium » Sat Jul 13, 2019 1:43 am

Virus4762 wrote:
Sat Jul 13, 2019 1:20 am
Really? A $30 billion company that's been generating negative free cash flows for 10+ years and still has almost no growth rate is expected to return positive free cash flows in the future?


I don't understand why someone would invest in companies like this when the are so many companies out there that are generating positive free cash flows with 20%+ YoY growth rates (and whose multiples aren't that much higher than companies like this).
Isn't that pretty much exactly what happened with Amazon though? They spent an inordinate amount of time losing money hand over fist gradually building up dominant positions in a number of markets, and a lot of those investments have only really started paying off recently.

Ultimately, I do not think you can really evaluate a business purely on the numbers. If a railroad was cash flow negative for a decade because they were laying down thousands of miles of track to serve cities where they do not have competitors, that would be a good thing. They'll have pricing power and will likely hit rapid growth soon, as their network begins to serve an extraordinarily growing number of city pairs. If that same railroad is cash flow negative because they were constantly buying increasingly fast trains in order to be able to keep up with competitors who are also buying faster trains in order to compete, that would be a really bad sign, as it means that the company is locked in an arms race that ultimately competes out all the profit to create increasingly good customer experience. Both of these scenarios would look pretty similar on a financials basis. Only one of these has much possibility for future growth and profits.

Valuethinker
Posts: 38433
Joined: Fri May 11, 2007 11:07 am

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Valuethinker » Sat Jul 13, 2019 4:20 am

Virus4762 wrote:
Sat Jul 13, 2019 1:20 am
Valuethinker wrote:
Sat Jul 13, 2019 1:10 am
Virus4762 wrote:
Sat Jul 13, 2019 12:56 am
For the past few months, I’ve been checking out many companies in the utilities sector and one thing I’ve noticed is that many of these companies have capital expenditures so great that they often exceed the company’s operating cash flow for the year (i.e. the company has negative free cash flow). Take Xcel Energy for instance: https://financials.morningstar.com/rati ... atform=sal. One could argue that, if the company decreased capex, it could achieve a positive free cash flow, but doing so would obviously destroy the company’s future growth. If the only way a company can stay relevant is by keeping free cash flows negative, does the company really have any value? Obviously, it must have value because many of these companies have a market cap of 10s of billions of dollars but where does that value come from? How would you even go about valuing a company with almost entirely negative free cash flows (and that will sporadically and rarely have positive free cash flows in the future)?

Thanks.
Take a look at the fracking sector. Many of those companies have generated no free cash flow in aggregate over time.

A similar dynamic applies to Tesla or many high growth companies like Uber.

Setting aside whether the value of these companies *should* be this high, it is worth remembering we are living in a world of negative interest rates, estimated 13 trillion dollars of assets guaranteeing a negative return out there. German government bonds in particular. In that case the market is not irrational to offer historically low borrowing rates (or very high equity valuations) to quite risky companies.

Biotech companies, many tech companies are good examples of cash flow negative businesses that can achieve very high future free cash flows for shareholders.

So in the Discounted Cash Flow model you have annual cash flows (which can be negative), timing of cash flows (positive can be in the future not now; for a company operating in high growth markets it is rational to chase growth over immediate returns).

We have argued above that discount rates on future cash flows are low due to macroeconomic conditions. So time matters less, returns in the future are worth more.

So there is your answer. The management of the company is making bets on future profits by making investments now. That leads to negative free cash flow now, which can be financed, and may lead to higher free cash flows in the future.

Really? A $30 billion company that's been generating negative free cash flows for 10+ years and still has almost no growth rate is expected to return positive free cash flows in the future?


I don't understand why someone would invest in companies like this when the are so many companies out there that are generating positive free cash flows with 20%+ YoY growth rates (and whose multiples aren't that much higher than companies like this).
As I say consider the fracking cos or something like Uber or Tesla.

If you can find cos that are double digit growth on reasonable multiples then perhaps you should invest in them? The market may be making a mistake.

Exelon may have its current share price due to the dividend yield it offers
Last edited by Valuethinker on Sat Jul 13, 2019 5:54 am, edited 1 time in total.

Grt2bOutdoors
Posts: 20986
Joined: Thu Apr 05, 2007 8:20 pm
Location: New York

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Grt2bOutdoors » Sat Jul 13, 2019 4:34 am

Virus4762 wrote:
Sat Jul 13, 2019 12:56 am
For the past few months, I’ve been checking out many companies in the utilities sector and one thing I’ve noticed is that many of these companies have capital expenditures so great that they often exceed the company’s operating cash flow for the year (i.e. the company has negative free cash flow). Take Xcel Energy for instance: https://financials.morningstar.com/rati ... atform=sal. One could argue that, if the company decreased capex, it could achieve a positive free cash flow, but doing so would obviously destroy the company’s future growth. If the only way a company can stay relevant is by keeping free cash flows negative, does the company really have any value? Obviously, it must have value because many of these companies have a market cap of 10s of billions of dollars but where does that value come from? How would you even go about valuing a company with almost entirely negative free cash flows (and that will sporadically and rarely have positive free cash flows in the future)?

Thanks.
The utility business is inherently different- it will have periods of time that require huge capital outlays to improve the efficiency and economic generating ability of the business, the capital expenditures however will be recouped with a generous return (in utility sector) through utility commission rate process. The rate base is the true asset and seeing how Xcel operates in 5 states, two of which have good demographics - one can infer that company is making a rational economic decision. It’s not enough on your part to just look at financial statements without having an in-depth understanding of the industry, regulations and company specific enviorment. These capital expenditures are for long-lived investments, try that in the technology sector where today’s capital expenditures are chasing dubious returns while its business is constantly evolving - the risk of investment becoming obsolete in two years is very high, making your 20% pie in the sky returns- a pipe dream. It’s not sustainable.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions

CppCoder
Posts: 898
Joined: Sat Jan 23, 2016 9:16 pm

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by CppCoder » Sat Jul 13, 2019 7:53 am

Remember, a company may also have intrinsic value based on assets. If you own a real estate business with one house to rent, you own the house outright, and have a month with no tenant, your monthly cash flow is negative (e.g., still paying property taxes with no rent). Is your business worthless or could you still sell the property?

User avatar
snackdog
Posts: 703
Joined: Wed Nov 12, 2014 4:57 am

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by snackdog » Sat Jul 13, 2019 2:44 pm

If their cash flow is negative long enough it will deplete their cash, cause them to suspend share buybacks and then dividends, eventually drive their debt ratio up and end in their bankruptcy. Sears is an example. United Airlines is another.

Caduceus
Posts: 1977
Joined: Mon Sep 17, 2012 1:47 am

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Caduceus » Sat Jul 13, 2019 6:17 pm

Well, if you think a company will never achieve positive free cash flows, then you will not invest in it unless you are offered such a compelling price to the fair value of its assets that you believe you can make money from it.

I do not know anything about utilities, but take a look at Buffett's analysis of utilities. He observes that utilities operate in a highly regulated environment, and therefore, they are unlikely to make either very good returns or very bad returns. The most likely scenario is a pattern where the utility has to make substantial capital investments for a period of time, but then will be allowed to earn a decent (but not obscene) return on its invested capital. So it may well be that the negative cash flows are temporary.

You did not define your definition of cash flow, and whether you are talking about free cash flow to equity or operating cash flow, but negative cash flow can result from a company making lots of capital investments, or from something quite different, like paying down existing debt instead of issuing new debt. Negative cash flow figures can and often do mask different economic realities, so you have to pierce behind the numbers to figure out what is going on.

Grt2bOutdoors
Posts: 20986
Joined: Thu Apr 05, 2007 8:20 pm
Location: New York

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Grt2bOutdoors » Sat Jul 13, 2019 9:05 pm

The OP needs to read the Management Discussion and Analysis section of the 10-k, read a few presentations on IR section of home page for Xcel. The company is sound.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions

Topic Author
Virus4762
Posts: 100
Joined: Fri Jul 13, 2012 10:53 am

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Virus4762 » Fri Aug 16, 2019 12:08 pm

Grt2bOutdoors wrote:
Sat Jul 13, 2019 4:34 am
The utility business is inherently different- it will have periods of time that require huge capital outlays to improve the efficiency and economic generating ability of the business, the capital expenditures however will be recouped with a generous return (in utility sector) through utility commission rate process. The rate base is the true asset and seeing how Xcel operates in 5 states, two of which have good demographics - one can infer that company is making a rational economic decision.
Rate base? What do you define as good demographics?




Grt2bOutdoors wrote:
Sat Jul 13, 2019 4:34 am
the risk of investment becoming obsolete in two years is very high, making your 20% pie in the sky returns- a pipe dream. It’s not sustainable.
What the hell are you talking about? When did I mention 20% returns?

User avatar
unclescrooge
Posts: 3606
Joined: Thu Jun 07, 2012 7:00 pm

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by unclescrooge » Fri Aug 16, 2019 12:23 pm

Iridium wrote:
Sat Jul 13, 2019 1:43 am
Virus4762 wrote:
Sat Jul 13, 2019 1:20 am
Really? A $30 billion company that's been generating negative free cash flows for 10+ years and still has almost no growth rate is expected to return positive free cash flows in the future?


I don't understand why someone would invest in companies like this when the are so many companies out there that are generating positive free cash flows with 20%+ YoY growth rates (and whose multiples aren't that much higher than companies like this).
Isn't that pretty much exactly what happened with Amazon though? They spent an inordinate amount of time losing money hand over fist gradually building up dominant positions in a number of markets, and a lot of those investments have only really started paying off recently.

Ultimately, I do not think you can really evaluate a business purely on the numbers. If a railroad was cash flow negative for a decade because they were laying down thousands of miles of track to serve cities where they do not have competitors, that would be a good thing. They'll have pricing power and will likely hit rapid growth soon, as their network begins to serve an extraordinarily growing number of city pairs. If that same railroad is cash flow negative because they were constantly buying increasingly fast trains in order to be able to keep up with competitors who are also buying faster trains in order to compete, that would be a really bad sign, as it means that the company is locked in an arms race that ultimately competes out all the profit to create increasingly good customer experience. Both of these scenarios would look pretty similar on a financials basis. Only one of these has much possibility for future growth and profits.
25% of my US equity holdings are in an ETF that holds companies that generate free cashflow, and use it to buy back stock (as opposed to using debt to buy back stock). The returns have been exemplary over the past 5 years.

Investing only in companies that generate FCF is a viable long term investment strategy.

Grt2bOutdoors
Posts: 20986
Joined: Thu Apr 05, 2007 8:20 pm
Location: New York

Re: What’s the value of a company whose capital expenditures are so high that it can’t achieve positive free cash flows?

Post by Grt2bOutdoors » Fri Aug 16, 2019 12:50 pm

Virus4762 wrote:
Fri Aug 16, 2019 12:08 pm
Grt2bOutdoors wrote:
Sat Jul 13, 2019 4:34 am
The utility business is inherently different- it will have periods of time that require huge capital outlays to improve the efficiency and economic generating ability of the business, the capital expenditures however will be recouped with a generous return (in utility sector) through utility commission rate process. The rate base is the true asset and seeing how Xcel operates in 5 states, two of which have good demographics - one can infer that company is making a rational economic decision.
Rate base? What do you define as good demographics?

If you don't understand how utility companies operate, I suggest you read the Form 10K, particularly the Management Discussion and Analysis. You can also visit the target companies website, under Investor Relations and view a few of their investor presentations. This ought to give you good color into your questions above. Then you can also read the Federal Reserve Beige Book, particularly for the districts whose states Xcel Energy operates in. You will need to do a bit of legwork in connecting the dots, there is no one document that is going to present a clear picture.


Grt2bOutdoors wrote:
Sat Jul 13, 2019 4:34 am
the risk of investment becoming obsolete in two years is very high, making your 20% pie in the sky returns- a pipe dream. It’s not sustainable.
What the hell are you talking about? When did I mention 20% returns?
Guess you forgot what you wrote down in a response to ValueThinker.
Virus4762 wrote:
Sat Jul 13, 2019 1:20 am
Valuethinker wrote:
Sat Jul 13, 2019 1:10 am
Virus4762 wrote:
Sat Jul 13, 2019 12:56 am
For the past few months, I’ve been checking out many companies in the utilities sector and one thing I’ve noticed is that many of these companies have capital expenditures so great that they often exceed the company’s operating cash flow for the year (i.e. the company has negative free cash flow). Take Xcel Energy for instance: https://financials.morningstar.com/rati ... atform=sal. One could argue that, if the company decreased capex, it could achieve a positive free cash flow, but doing so would obviously destroy the company’s future growth. If the only way a company can stay relevant is by keeping free cash flows negative, does the company really have any value? Obviously, it must have value because many of these companies have a market cap of 10s of billions of dollars but where does that value come from? How would you even go about valuing a company with almost entirely negative free cash flows (and that will sporadically and rarely have positive free cash flows in the future)?

Thanks.
Take a look at the fracking sector. Many of those companies have generated no free cash flow in aggregate over time.

A similar dynamic applies to Tesla or many high growth companies like Uber.

Setting aside whether the value of these companies *should* be this high, it is worth remembering we are living in a world of negative interest rates, estimated 13 trillion dollars of assets guaranteeing a negative return out there. German government bonds in particular. In that case the market is not irrational to offer historically low borrowing rates (or very high equity valuations) to quite risky companies.

Biotech companies, many tech companies are good examples of cash flow negative businesses that can achieve very high future free cash flows for shareholders.

So in the Discounted Cash Flow model you have annual cash flows (which can be negative), timing of cash flows (positive can be in the future not now; for a company operating in high growth markets it is rational to chase growth over immediate returns).

We have argued above that discount rates on future cash flows are low due to macroeconomic conditions. So time matters less, returns in the future are worth more.

So there is your answer. The management of the company is making bets on future profits by making investments now. That leads to negative free cash flow now, which can be financed, and may lead to higher free cash flows in the future.

Really? A $30 billion company that's been generating negative free cash flows for 10+ years and still has almost no growth rate is expected to return positive free cash flows in the future?


I don't understand why someone would invest in companies like this when the are so many companies out there that are generating positive free cash flows with 20%+ YoY growth rates (and whose multiples aren't that much higher than companies like this).

"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions

Post Reply