What Determines Share Prices?

What determines shareholder value? What drives long-term share price performance?

The boring answer is the present value of a business’s sustainable long-term future cash flows.

Fundamentals matter.

Fundamentals exert a gravitational pull. In the end, a stock’s price will orbit the firm’s underlying financials.

As the authoritative manual on valuation by McKinsey notes:

‘Relative value methods do not value directly what matters to investors. Investors cannot buy a house or car with earnings. Only the cash flow generated by the business can be used for consumption or additional investment.’

My fourth edition of McKinsey’s Valuation has a straightforward proclamation for investors (emphasis added):

‘Share prices are determined by long-term cash flows. To test the stock market’s time horizon, we examine how much of a company’s share price is accounted for by expected cash flows over the next several years. For a subset of S&P 500 companies, dividends expected in the first five years explained less than 9 percent of the market value, on average, another illustration of the market’s long-term view. Whether considering biotechs or the largest blue chips, investors value long-term cash flows.’

Amazon and Apple — cash flow kings

We can test out the claim that share prices are determined by long-term cash flows by considering some of the largest stock success stories.

Consider Amazon. Its share price is up more than 100,000% since it came onto the market.

A large reason why? Its massive cash flow generation.

I graphed Amazon’s operating cash flow since 2000 in three-year increments as a quick demonstration of Amazon’s long-term cash flows:

It’s a similar story with Apple.

Since its inception, Apple shares have gained 140,000%, in large part thanks to its impressive cash flow generation:

Clearly, investors have appreciated Apple and Amazon’s long-term cash flows and valued them accordingly.

As McKinsey’s Valuation tome repeatedly stresses, it is the sustained cash flow generation that plays the crucial role in a company’s valuation…not necessarily earnings.

That’s well illustrated in Amazon’s case.

As the Harvard Business Review graphic shows below, Amazon’s historical net income doesn’t exactly paint a picture of a romping stock.

But its operating cash flow does…

Jeff Bezos offered an explanation as to why net income can be misleading in a 2004 letter to Amazon shareholders:

‘Why not focus first and foremost, as many do, on earnings, earnings per share or earnings growth? The simple answer is that earnings don’t directly translate into cash flows, and shares are worth only the present value of their future cash flows, not the present value of their future earnings. Future earnings are a component—but not the only important component—of future cash flow per share. Working capital and capital expenditures are also important, as is future share dilution.’

In the end, valuations track generated cash flows. Fundamentals always win out in the end.

We can see that with ‘Buy now, pay later’ (BNPL) stocks.

BNPL and the long-term cash flow vacuum

BNPL stocks rocketed in value a few years ago as investors were swayed by the sector’s rapid adoption rates and top-line growth.

Investors were excited about what the largest BNPL stocks like Afterpay and Zip could look like in five or 10 years if they continued to grow at this pace.

But the dramatic collapse of BNPL stocks that started in 2021 reflects the market’s deteriorating confidence in BNPL’s long-term value-creation prospects.

While the likes of Amazon and Apple saw their cash flows rise steadily over the years, BNPL stocks continue to burn cash without a turnaround in sight.

Take Zip, for example.

Zip reported negative operating cash flows of $752 million in FY22.

Despite taking out $1.2 billion worth of loans during the year, it still managed to end FY22 with $29.4 million less cash than it started the year with.

While Zip continues to grow revenue rapidly, it’s not converting that revenue into value.

In fact, you could argue that Zip’s revenue growth is destroying value.

Value can only be created when a firm’s return on invested capital is greater than its cost of capital.

Value is the efficiency with which a business converts revenue into cash flows.

As McKinsey’s Valuation book summarises:

‘The conversion of revenues into cash flows—and earnings—is a function of a company’s return on invested capital (ROIC) and its revenue growth. That means the amount of value a company creates is governed ultimately by its ROIC, revenue growth, and ability to sustain both over time. Keep in mind that a company will create value only if its ROIC is greater than its cost of capital. Moreover, only if ROIC exceeds the cost of capital will growth increase a company’s value. Growth at lower returns actually reduces a company’s value.’

The arc of valuation is long, but it bends toward cash flow.

Until next week,

Kiryll Prakapenka,
For Money Morning