Free Cash Flow Rules: AmEx, Mohawk

This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

We've all heard the saying that "cash is king," but in investing, I like to say that "free cash flow" (FCF) is king. Profits are great, but they don't count for much in the long-run if a company is not generating FCF. After all, FCF is the money left over after a business pays all its bills.

A few perfectly legitimate accounting adjustments can tweak earnings to management's delight, but at the end of the day, it's the cash that's left over that counts. Businesses that produce healthy amounts of free cash flow can be valued with a higher degree of certainty and margin of safety than simply going on profits.

With everyone sour on the market today, several wonderful businesses continue to pour out fantastic levels of free cash flow and are thus increasing intrinsic value while the equity price sits still. Sooner or later the stock price will catch up.

Cash Can Be Counted

Unlike profits, free cash flow can not be manipulated by the magic stroke of the accounting pen. An inventory adjustment here, extension of generous credit terms there, and you can manufacture a profit number without doing anything illegal.

However FCF, or cash flow from operations less capital expenditures, can't be manipulated through accounting changes. Remember that the value of any business is the present value of the future cash flows of the business.

Cash Cow at American Express

One of the world's most dominant consumer brands is currently trading at levels not seen for years. At $43 billion dollars, American Express ( AXP) is trading at about 6 times 2007 free cash flow of some $7.5 billion. At six time's free cash flow, this would imply that Amex is trading at a free cash flow yield (annual FCF divided by market cap) of nearly 17%! So far, Amex has been producing healthy levels of free cash flow in 2008, suggesting that the overall business remains sound

Obviously the red flag here is the uncertainty with how the credit crisis will affect the credit card industry. It's decimated the mortgage industry, as evidenced by the billions in writedowns from Citigroup ( C), Merrill Lynch ( MER), and company.

I discussed my reasons for Amex's solid long-term prospects in an earlier article RealMoney access required . Amex is still generating solid amounts of cash that lend credibility to the business model.

As the company operates a closed-loop network, it can keep an eye on the entire credit process (unlike possible transparency issues between banks and the other credit card processors). In my view, if Amex continues to roll in the dough, shares should be trading at around 12 times FCF or at 2007 levels, around $90 million or twice today's value.

Laying Down the Cash

Value investors love to seek out bargains in distressed industries. One such opportunity exists with Mohawk Industries ( MHK). Mohawk produces and sells floor-covering products for residential and commercial customers. It's the "residential" side of the business that has weakened and taken the stock price for a ride.

Mohawk and Shaw Carpet, a unit of Berkshire Hathaway ( BRK), have a duopoly over the carpet and flooring industry. The two command over 60% of the flooring market. At $66 a share, the market value of Mohawk is $4.6 billion. Over the three years during 2005-2007, free cash flow was $314 million, $615 million, and $710 million, respectively. So far in 2008, free cash flow has been $215 million, but that was with a $200 million charge to working capital in the first quarter.

So what's this cash worth? Let's make some quick, yet conservative assumptions. Considering the phenomenal growth rate in free cash flow over the past three years, let's assume that 2008 free cash flow comes in at $500 million, $210 million less than 2007 (we'll assume a transition year).

Beginning in 2009, it's reasonable to expect free cash to grow by 12% a year for the next four years. Given Mohawk's dominance, I think it will be much more, but let's be conservative. Let's also assume a discount rate of 10%. For a business as strong as Mohawk, 10% might be a notch too high but the goal is to get a really conservative valuation. The numbers are as follows:

Mohawk's Prodigious Free Cash Flow
Year FCF Present Value of FCF
@ 10% discount rate
2008 $500m $455m
2009 $560m $463m
2010 $627m $471m
2011 $702m $480m

The sum of the present value of the cash flows is $1.87 billion. Given that Mohawk has grown its profits and cash flow in the high teens for some time, the company's terminal value could easily be worth 15 time's free cash flow of 2011. Discounted back to the present, you get a value of $7.2 billion ($480M *15), or a total company value of approximately $9 billion ($7.2 + $1.8).

Assume shares outstanding increase by 5% percent over the four years to 72 million from 68.5 million today. Since 2004, diluted shares outstanding rose by only one million shares (less than 2%). A $9 billion market cap over 72 million shares equals a share price of $125 in 2011, up from $66 today.

And this valuation hinges on conservative assumptions, but I think it's wise to invest with a wide margin of safety.

Focus on Cold Hard Cash

Fixation on cash generation keeps your analysis focused on what counts. Of course, there will be special investment situations that will be require another set of valuation parameters, but special situation investments are few and far between. Yet in markets like these, with everyone rushing to sell at the first sign of trouble, many wonderful businesses are producing gobs of cash and going unnoticed. It won't last long.

This was originally published on RealMoney on August 15, 2008. For more information about subscribing to RealMoney, please click here.

At the time of publication, Gad was long Berkshire Hathaway, although positions may change at any time.

Sham Gad is the managing partner of the Gad Partners Fund, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.

Gad also runs a value investing blog inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at sham@gadcapital.com.