Joel Stern and Free Cash Flow

Joel Stern was a “roving ambassador” for Chase Manhattan Bank. He conducted classes for the bank’s major clients. I took two of his courses. His valuation concepts were a real eye-opener for me, and I have used them religiously for over fifty years.

Joel later founded a consulting firm, still active today, Stern Value Management. He developed the concept of “economic value added (EVA) and is an authority on corporate performance measurement.

The cash flow concept is common sense. A profit and loss statement has many assumptions about what is a sale and what is a cost. But the bottom line is how much cash the company has generated to either reinvest or pay to the stockholders. This free cash flow, the money left over after all expenses including income taxes, is the only wealth that the enterprise will ever create for its owners regardless of how the books are kept. It comes either from operations or from a final payment if the business is sold.

This Rule is irrefutable whether a multinational behemoth or a personal savings program. Investors who ignore it do so at their peril.

We have provided a detailed sheet of free cash flow for each operating business. Each lists the key elements of cash flow:

  1. Sale of assets minus Initial investment in the business.
  2. Plus Net earnings after taxes for the operating company
  3. Plus Depreciation, a non-cash charge that represents cash flow to the company.
  4. Less Capital expenditures on new equipment and factories.
  5. Less Change in working capital

Their sum represents the cash flow that the company is generating. That stream can be discounted to a present value and the percent return that the investment made. The return is shown on the total money invested, Return on Capital Employed (ROCE) also called Return on Investment (ROI).

But the real question is what is the return to the owners of the business – the return on their equity (ROE)? It depends on how much money the company has borrowed to finance its operations. For this, we assumed a constant ratio of financing for the company – one dollar of debt for each four dollars of investors’ equity. (The debt/equity ratio is .25). Generally, the higher this ratio, the higher the return on equity. But the more debt a company has, the riskier the business becomes. It may have trouble meeting its debt payments in bad economic times.

Another principle of Joel Stern comes to bear – a company with multiple operations needs an overall target debt/equity ratio. If one business unit employs more debt, perhaps giving it a higher assumed return on equity, then another business unit will be penalized because the company’s borrowing power is limited, and it must borrow less debt to finance the second business unit. Consequently, all the businesses must adhere to the same capital structure or borrowing level. One unit must not be assumed to have an advantage over its sister units because it borrowed more money.