KARL KAUFMAN | From American Dream Investing

· Podcast Episodes
Cash talks - the power of Free Cash Flow

Understanding Free Cash Flow: The Key to Smart Investing

If you're new to the world of investing, the terminology and metrics can be overwhelming. However, one metric that stands out as a crucial factor for successful investing is Free Cash Flow (FCF).

Karl Kaufman is the founder of American Dream Investing. In this episode he sheds light on the significance of FCF and its impact on investment decisions.

FCF is the cash left over after a company pays all its expenses and capital expenditures (such as equipment and plants). It excludes operating costs, making it a valuable measure of how much cash a company has available to allocate to different purposes. Karl emphasized that FCF is a more reliable metric than earnings since it's harder to manipulate and can reveal a company's true financial health.

Karl stressed that investing is not gambling. As an investor, you become a shareholder in a real business, one that produces actual products and services. Unlike casino gambling, investing has a long-term goal of generating good returns from your investment. This critical distinction sets the foundation for a successful investment journey.

So, where can beginners find and understand FCF data? Karl recommended financial websites like Yahoo Finance, Morningstar, or Seeking Alpha, which offer free access to FCF figures. Armed with this data, investors can make more informed decisions about their investment choices.

One useful ratio that complements FCF analysis is the FCF margin. By dividing FCF by sales revenue, investors can see how much cash a company generates per dollar in sales. A higher FCF margin indicates a company's ability to generate more cash from its operations.

As with any investment decision, it's essential to look beyond the static numbers. Karl suggested analyzing the growth of FCF over several years to gauge a company's financial health. Consistent growth in FCF signifies a company's ability to reinvest in itself, make acquisitions, pay dividends, and provide better returns for shareholders.

Karl highlighted two companies, Broadcom and Apple, as examples of impressive FCF growth. Broadcom, a hardware-focused company, saw its FCF rise during the pandemic, indicating its financial resilience. Meanwhile, Apple's astounding FCF figures demonstrate its strong cash-generating capacity and smart capital allocation, including stock buybacks, which benefit shareholders.

While technology companies like NVIDIA and Tesla often dominate headlines and generate FOMO (Fear of Missing Out), Karl cautioned against getting caught up in the hype. It's crucial to invest with a long-term perspective and believe in a company's growth potential.

In conclusion, understanding FCF is a vital aspect of successful investing. It allows investors to assess a company's financial health, growth potential, and capital allocation strategies. By using reputable financial websites to access FCF data, investors can make informed decisions and build a robust and rewarding investment portfolio over time. Remember, investing is not gambling; it's an opportunity to invest in the future of businesses and become a shareholder in real-world ventures.


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[00:01:02] Chloe:

Stocks for Beginners. Phil Muscatello and Finpods are authorized reps of Money Sherpa. The information in this podcast is general in nature and doesn't take into account your personal situation.

[00:12:01] Karl Kaufman:

Investing is not gambling if you approach it the right way. As an investor, you own shares in a real business. You're not going to the blackjack table and giving your money to the house. You're buying a piece of a real business, making real products and services. And you usually have a long-term goal of getting a good return on that investment. You're investing in the future of business.

[00:37:29] Philip Muscatello:

Hi, and welcome back to Stocks for Beginners. I'm Phil Muscatello. There's a plethora of numbers and valuation techniques when you first start looking at company reports. Is there a simple measure that can help you weed out the losers and focus on stocks that have a better chance of performing well?

I'm joined today by someone who believes that free cash flow is one of those metrics. Thanks for coming back on the podcast. Karl Kaufman.

[01:03:13] Karl Kaufman:

Thank you, Phil. It's great to be back.

[01:05:12] Philip Muscatello:

It's great to have a Bruce Springsteen tragic back on. Karl Kaufman is from American dream investing. We're basing this conversation on a Twitter thread about FCF free cash flow.

So let's just start by explaining what is free cash flow.

[01:24:11] Karl Kaufman:

Free cash flow is the amount of cash that's left over. That a company has after it's paid its expenses and its capital expenditures, which are the funds that are reinvested into the company to buy equipment or plants or, yeah, that's it. Sorry.

[01:46:25] Philip Muscatello:

That's it. But doesn't it include operating costs as well?

[01:50:13] Karl Kaufman:

It doesn't include operating costs, right. It's the operating cashflow minus the capital expenditures.

[01:57:12] Philip Muscatello:

Okay. So that's like where the offices are or where the factories are, whatever it is producing, this is just the amount of cash that's coming into the company. Is that right?

[02:08:06] Karl Kaufman:

Yeah, a great way of seeing what kind of cash is available to the company after all of it's big expenses are taken care of so they can really be more flexible with how they allocate that cash to shareholders, which I'm sure we'll get into in a minute.

[02:27:08] Philip Muscatello:

Yeah. So where do you find this number? Where can you see it?

[02:33:14] Karl Kaufman:

There's a statement of cash flows that a company has to report every quarter alongside it's. You know, P and L income statement and the balance sheet. It's very easy for an individual investor to find it on a site like Yahoo finance or Morningstar or, whatever financial app you use for numbers.

[02:56:09] Philip Muscatello:

So you mentioned a favorite quote of yours, "Profit is opinion. Cash is fact." What does this mean for beginner investors and how does it align with the focus on free cashflow?

[03:07:01] Karl Kaufman:

So earnings can be massaged by very good accountants. There are certain line items that can be messed around with, if you will.

So, for instance inventory or accounts receivable, especially between quarters. A company can report earnings that have account receivables, which is the money that's due to come in, or account payables, which is... Money that's due to come out and they can kind of push it to the day after the quarter ends or the day before the quarter ends, depending on what kind of earnings they're looking to show.

And a great book to that goes into that is called Financial Shenanigans by Howard Schillet. Highly recommended. A company can also hide some trickery in their footnotes on their 10 K's or 10 Q's. So, It's a lot harder to hide the free cashflow. It's everything after all that stuff has been taken out.

I'm sure most investors have heard of EBITDA, which is earnings before interest, tax, depreciation, amortization. Free cashflow basically is what happens when they add some of that back end.

[04:27:03] Philip Muscatello:

So that's, part of that famous Charlie Munger quote, isn't it? About when he sees EBITDA, he sees bullshit.

[04:33:24] Karl Kaufman:

Right. Right. Okay. There you go. Right. Yep.

[04:36:29] Philip Muscatello:

Or , something to that effect, Karl.

[04:40:17] Karl Kaufman:


[04:42:08] Philip Muscatello:

So that's interesting, isn't it? So free cashflow is just basically money coming in. That's it.

[04:47:27] Karl Kaufman:

Money coming in, money coming out also.

So, why I like free cashflow as an investor, why it's my favorite thing is that it could be used to enrich a shareholder. F irst and foremost, a company can reinvest it in itself which can drive growth. If management is efficient at growing the business by allocating capital appropriately, company can also pay down some of its debt especially some of the shorter term debt, with higher interest rates.

Now that rates are up higher than they were a year or two ago, free cash flow can be used for acquisitions and takeovers without requiring leverage to take on more debt for a deal. One of my favorites. They can be used for paying dividends or growing those dividends even better. We love, dividends.

Oh, we love growing dividends, especially if they outpace inflation. That's, that's the best.

[05:45:05] Philip Muscatello:

That's the harvest that's provided by the company they invest in. Isn't it?

[05:49:10] Karl Kaufman:

Yep, yep. But a lot of investors like Warren Buffett, for example, loves a company that buys back its shares because that's even more tax efficient. When a company gives out a dividend, like double taxation in a way when it buys back its shares. It makes you as the shareholder own more of the company.

[06:12:07] Philip Muscatello:

And that's an interesting thing just to focus on for a moment is that a company with capital, has several ways that it can allocate that capital. And I think you mentioned one is to do a buyback, which basically makes the value of each share leftover worth a bit more. It can make acquisitions, it can pay out dividends.

What's the relationship between those and free cashflow?

[06:37:17] Karl Kaufman:

Well, if a company has the cash , they can do whatever they want with it. And it, makes them a lot more nimble in their operations. And you can see how shareholder friendly a company is based on what they do with their free cash. Dividends for me are nice because it offers a commitment from management that they will be paying a portion of their earnings out to shareholders as a reward board for being a shareholder.

[07:09:22] Philip Muscatello:

Presumably that requires a trust in management that they are going to manage this capital well.

[07:16:22] Karl Kaufman:

Yep. Yep. That's what you're doing. You're putting faith in management. When you're doing fundamental analysis, management is the hardest thing to really quantify because

It's very subjective . You're judging a person as opposed to a number and how a person allocates their capital, runs their business, are they a good leader? Do you trust them? Those are kind of things that you need to intuit over time. And that's comes with lot of studying of the markets and of people.

One of the reasons why I like to watch CNBC is that they do have interviews with CEOs of stocks that I own. And so, I could watch a CEO be grilled or take softball questions depending on the reporter, of course, and see what their responses are and it's, almost like a game. And can you see , if they're telling the truth, , do you see if they're confident in themselves and in their company and the future prospects of the company itself?

[08:21:22] Philip Muscatello:

Because CEOs are basically salespeople, aren't they?

[08:25:16] Karl Kaufman:

One of their many hats. Yeah.

[08:27:03] Philip Muscatello:

You've got to keep that in mind as well. They want a visibility for their company.

[08:32:05] Karl Kaufman:

Yeah. Yeah. And no one wants to go on CNBC and explain their lousy [00:08:00] quarter or the accounting irregularities , that were basically another name for fraud that were uncovered by a previous journalist.

[08:47:22] Philip Muscatello:

I believe it's also important to look at the growth of free cashflow. It's not just, you just don't look at one static number, but you look at that over a number of years. Tell us about that process.

[09:00:20] Karl Kaufman:

Sure. So free cashflow, just like any number that you're looking at doing analysis, you want to see growth in that area. Just as you want to see earnings growth, revenue growth, share price growth all of that comes into play.

So, if you see it that a company is steadily growing its free cash flow over time, that's a good sense that they will continue to grow their share price, earnings, of course, drive share price , that's a big saying, but free cashflow will certainly help move that along to a greater effect in my opinion.

[09:41:01] Philip Muscatello:

This is one of the things that I've discovered is that when you're talking to people and because they know that you've got a financial podcast or in your case, you're an investor as well. I'm sure you get a lot of people coming up to you going, "Oh, what do you think of blah, blah, blah company." And I've realized now that the perfect response is, well, are they making money? Because there's so many companies on share markets and stock markets around the world that aren't even generating any income.

[10:07:26] Karl Kaufman:

Right. You look at the Ubers or the Snapchats of the world and they get a lot of attention and they got a lot of press because a lot of people are using their products and services, but they ain't making any money.

So you have to, believe that someday they will be profitable and maybe Uber just started earning a profit recently, but you have to have faith that they will continue to be profitable and then grow that profit over time. An argument could be made that Amazon was not profitable for so long.

But if you actually look at the money that they were actually investing into R and D into driving growth in the business through research and development, if you took that out, then they were very profitable.

[11:01:09] Philip Muscatello:

And so they were plowing all of the cash into building up the business over the long term.

[11:08:06] Karl Kaufman:

Right. And that paid off over time. You had to be very patient for that to happen and go through some big downturns, especially when the bubble burst in the turn of the century here.

[02:16:17] Philip Muscatello:

And there's been a lot of expectations. Investors expect sometimes at a company like say Snapchat, for example. The support of the share price is basically only on those expectations that one day it will generate some money, isn't it?

[12:32:21] Karl Kaufman:

Yeah. I mean the same thing [00:11:00] holds true for companies that are profitable. If you look at a Tesla or an NVIDIA, I mean, their PE ratio, their multiples are huge compared to a profitable company like Pfizer or an Exxon mobile.

You know, you're paying 50, a hundred. 150 times of earnings in their share price compared to a boring fuddy duddy business , like Pfizer or a Merck or a big Pharma company that, those are just cash generating machines.

[13:11:07] Philip Muscatello:

And this is where companies can get hammered when interest rates, as we've seen recently, how interest rates have gone up and certain companies last year, they seem to be recovering at the moment, but certain companies last year were really hammered because suddenly these interest rate rises really did affect the cash flow.

[13:30:22] Karl Kaufman:

Yeah. And the price that investors were willing to pay for their future earnings. And so that expectation kind of withered in a quick timeframe and now those expectations are getting massive, especially for a handful of companies, especially that everybody's banking on the AI revolution here and,

[13:53:15] Philip Muscatello:

Yeah. It's the latest trend, isn't it?

[13:55:01] Karl Kaufman:

It's the latest trend. You can get caught up in that and chase that. I'm sure a company like Pfizer is going to be using artificial intelligence to develop drugs, but it's not going to drive headlines like NVIDIA or a Tesla would.

[14:10:26] Philip Muscatello:

It's interesting, isn't it that these stories come about and suddenly people get so excited about it and they think that the change is going to happen and they've got all these different scenarios, or you've got to get into NVIDIA because they're going to be powering the AI revolution, or I just heard about a Dutch company that actually makes the machines that makes the chips that Nvidia uses. And people are piling in on that AMSL, I think is the code for that one. There's hype and then the excitement seems to die down, doesn't it?

[14:38:17] Karl Kaufman:

Yeah . There's that crazy term called FOMO, which, which is big. The fear of missing out. Right? I think the hardest part of being an investor is the emotional aspect of it and not getting caught up in that craze, you know, to step away from the nitty gritty of the free cash flow for a minute, when you're dealing with emotions.

And you're dealing with a portfolio as an individual investor. Warren Buffett, it says you don't have to swing at every pitch. Right? So you can feel free to ignore the NVIDIAS and the Tesla's of the world and you'll do fine. Your portfolio rise a hundred percent in six months, maybe not, maybe it will with a different stock. But FOMO drives up the number that people are willing to pay for the stock.

And when people are willing to pay any price for a stock, no matter what, that's when bubbles start to form. And we know what happens , with bubbles.

[15:46:09] Philip Muscatello:

Oh yeah. Can you share a real life example of a company with impressive free cashflow growth and how that growth translates to good news for investors?

[15:56:12] Karl Kaufman:

Sure. So , I have two here. And they both coincidentally have something to do with AI. There's, there's, just by the by, just by the by, right? There's Broadcom, which is more of a tangential way to play artificial intelligence.

Here's a company , that's growing his dividend by, I don't know, I think 17% a year or something like that, which I salivate over like Pavlov's dog there. But here we go. The last four years of free cash flow for Broadcom, the ticker symbol is AVGO. In 2019, their free cash flow was 9. 265 billion.

Following year 11. 598 billion, 2021 13. 321 billion and last year 16. 312 billion. Now that was in the midst of a pandemic and they're still growing their free cashflow. That sounds pretty appealing to me. Of course, the big dog itself is Apple. And you know, from my past appearance on the show that I'm a big Apple fan.

Apple is just their free cash flows numbers are staggering. In 2019, they did 58 billion. 2020 they did 73 billion, 2021, 92 billion. And last year they did 111 billion dollars in free cash flow. I mean, that's the GDPs of several countries.

[17:29:21] Philip Muscatello:

That's just astonishing, astonishing amounts of money. Yeah.

[00:15:54] Karl Kaufman:

That's just cash that they have available to do whatever they want with. It's very [00:16:00] powerful. And so Apple is trading at a higher valuation than usual. It's around 29 times earnings, but, you are getting 111 billion dollars plus share buybacks. It's just, it's a growth machine, even as its growth seems to be slowing in other facets of its business as far as iPhone sales, it's still bringing in the cash.

[17:59:11] Philip Muscatello:

So Apple are very fond of stock buybacks, aren't they? Which is great for investors.

[18:05:12] Karl Kaufman:

Yeah. And if you read Warren Buffett's shareholder letter from last year, he goes into the specifics on how without buying any more shares, his stake in the company has gotten bigger over time. And , that makes Berkshire Hathaway more valuable and it makes his shareholders happy.

But just being an Apple shareholder, you own more of a company and their float or the number of shares outstanding going down just makes. Every bit of earnings that more valuable.

[18:40:28] Philip Muscatello:

And again, that's an example of capital allocation, isn't it?

[18:45:24] Karl Kaufman:

Absolutely. Yep. A company can take out a debt to buyback shares that's very common, but , when interest rates were near zero, that would have been a good time to do it. And I think Apple was issuing debt at 0.5% or 1% interest rates. People were willing to pay for it in 2021 to buy back shares because they knew their shares were so much more valuable than, whatever interest they would be paying on the debt.

[19:13:26] Philip Muscatello:

So that's a decision that a management would make, isn't it? About trading off the cost of interest on using their capital, as opposed to deploying their free cashflow.

[19:25:22] Karl Kaufman:

Sure. Yeah. I mean, just as an individual investor can decide to use margin to buy shares that they think will appreciate more than the interest they're paying on the margin, or even if you get a mortgage on your house and you pay the interest on the mortgage, instead of paying cash on the house, because you know, you can use the cash to put it in the market and get more return on your money.

[19:50:29] Philip Muscatello:

Can we just look a little bit more deeply at Broadcom? Where does Broadcom operate and earn its revenues?

[19:58:22] Karl Kaufman:

Yeah. Broadcom is more of a hardware operator. They do a lot of modems and they're like the picks and shovels of the AI to use an oft quoted metaphor.

That's why they're more of a tangential play because they're doing kind of the behind the scenes work as opposed to the software in Microsoft with their open AI partnership or even NVIDIA with the chips.

[20:26:11] Philip Muscatello:

So how can beginners find and understand free cashflow data? Are there any easy to use tools or resources you recommend?

[20:33:00] Karl Kaufman:

Yeah, certainly. My favorite [00:19:00] is Yahoo Finance. It's the easiest one. You could just go on their financials tab and look at their free cashflow and it'll show you, I think they have about five years of data, four or five years available for free. Morningstar is also a good one and Seeking Alpha.

[20:53:16] Philip Muscatello:

Isn't Morningstar's a subscription service though?

[20:57:16] Karl Kaufman:

Yeah, they'll give you maybe three years of data for free. If you want to go further, you'll have to pay for it. I think Seeking Alpha will have that information. I think any of the big sites would have that information freely available for at least the past few years.

[21:13:27] Philip Muscatello:

Yeah. Karl, are there any other favorite jratios that you add to your investing recipe book?

[21:20:05] Karl Kaufman:

Yeah, when it comes to free cash flow, there are a couple that dig deeper into how efficient that free cash flow is being used or generated. So one of them is a free cash flow margin and [00:20:00] that you calculate by taking the free cash flow and you divide by the sales. And so that just shows you how much cash a company generates per dollar in sales revenue.

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[22:33:02] Philip Muscatello:

When you say sales, what is that particular number?

[22:35:27] Karl Kaufman:

So sales is the top line. That's the revenue. So if you're selling a widget for $20, that would be $20, but then, the earnings are how much it costs to generate that $20 sale.

So it would take out, salespeople, marketing over any overhead costs for the business, so on and so forth.

[22:55:08] Philip Muscatello:

Can you give us a real life example of how free cash flow margin operates?

[23:01:16] Karl Kaufman:

Sure. So you could take a company like Apple and you look at their sales and their free cash flow and come to a bit of a calculation here. So their sales , or the revenue were 94, [00:21:00] 836, 000, 000 over the last quarter. And their free cash flow last quarter was 22, 445, 000, 000 give or take. So , you just divide 22, 445, 000 and 94, 836, 000 and you get about 24%. As their margin for just free cashflow based on their revenue.

[23:50:11] Philip Muscatello:

And what does that say to you?

[23:52:12] Karl Kaufman:

That says that almost a quarter of every dollar that they bring in is going to free cashflow. And that says, yes, please.

[24:03:15] Philip Muscatello:

Give me more. Yeah. Even though this is not a recommendation to buy by any means. The general advice only. Yeah.

[24:11:02] Karl Kaufman:

This is, what I own. So,

[24:14:04] Philip Muscatello:

So you're a music tragic, Karl, and what song has helped you to more deeply understand investing? And I'll just want to say one of mine, there's an Australian song called I've done all the dumb things. It's called dumb things, but it's the chorus goes, I've done all the dumb things. And for me, that's informed me up until quite recently. How about you?

[24:35:26] Karl Kaufman:

Yeah, that's a great one . For me, like we said at the beginning of the episode, a huge Bruce Springsteen fan, and , I hear all the time that the stock market is a casino, right? Or it's like gambling. So for me, Bruce Springsteen's song Atlantic City is very apt. Atlantic City is a huge gambling town in New Jersey, in the States, Bruce Springsteen's home, home state. And i In my opinion, investing is not gambling if you approach it the right way, as we kind of went into throughout the episode. As an investor, you own shares in a real business, right? You're not going to the blackjack table and giving your money to the house. You're buying a piece of a real business, making real products and services.

And you usually have a long term goal of getting a good return on that investment. If you're a day trader or a speculator, that's gambling in a way there's nothing wrong with that as long as you understand that you're speculating , that you're, betting on something to happen and outcome to happen, whether it's a good earnings report or the federal reserve rising interest rates or a recession to happen.

But if you're investing, you're not gambling. You're actually investing in the future of business. And I find that very rewarding and I'm happy to be an investor in many of the companies I own.

[26:12:11] Philip Muscatello:

Because they're working on your behalf, aren't they?

[26:15:03] Karl Kaufman:

They are. And anytime somebody buys an iPhone, I'm getting a very, very, very, [00:24:00] very, very, very, very small part of that.

[26:27:00] Philip Muscatello:

Yeah, the numbers seem eye watering. I saw a tweet this morning that said that Google started with a check for $100, 000 and now Alphabet generates $100, 000 every 18 seconds.

[26:38:20] Karl Kaufman:

Man, it's staggering when you see how the world economy has shape itself. The fact that we're able to do a podcast in different time zones on the other side of the world, just goes to show , how much of a global economy this is.

And so, to own a piece of a business that's generating sales throughout the world to enrich people's lives is quite a nice thing to do.

[27:07:18] Philip Muscatello:

So tell us about your Twitter handle because we can find out more about this particular thread on your Twitter feed and American Dream Investing.

[27:16:10] Karl Kaufman:

Yeah, I'm really enjoying posting on Twitter. I try to post something new every day.

[27:23:22] Philip Muscatello:

Do we call it Twitter anymore? Is it X now?

[27:25:28] Karl Kaufman:

Oh, X, I'm not sure. Yeah, I'm always going to call it Twitter unless they convinced me it's worth my while otherwise. But yeah, my handle is the Karl Kaufman. And, yeah, I try to, share some wisdom from others, whether it's a Warren Buffett quote, or a funny quote from Charlie Munger or from someone else.

I try and break down complicated concepts of investing in short bite sized pieces so that it's, easy to understand and I try to make it entertaining and amusing . And you'll get my opinions and commentary on what's going on in the markets and skometimes my own portfolio too.

[28:12:11] Philip Muscatello:

And American Dream Investing, where can listeners find out more?

[28:16:08] Karl Kaufman:

Yeah. AmericanDreamInvesting. com is where you could find [00:26:00] my email list. And I also have a premium membership where I basically pull back the curtains and show all members what stocks are in my portfolio, how it's comprised. And I send text message and email alerts every time I make a trade.

I just bought some shares today. And they could see how a long term active investor manages a portfolio over time.

[28:51:06] Philip Muscatello:

Karl Kaufman, thank you very much for your time today. It's been a pleasure having you back on.

[28:55:20] Karl Kaufman:

Thank you, Phil. Looking forward to talking to you again real soon.

Stocks for Beginners is for information and educational purposes only. It isn’t financial advice, and you shouldn’t buy or sell any investments based on what you’ve heard here. Any opinion or commentary is the view of the speaker only not Stocks for Beginners. This podcast doesn’t replace professional advice regarding your personal financial needs, circumstances or current situation.