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If you are currently a shareholder in Continental Aktiengesellschaft (FRA:CON), or considering investing in the stock, you need to examine how the business generates cash, and how it is reinvested. What is left after investment, determines the value of the stock since this cash flow technically belongs to investors of the company. Today we will examine CON’s ability to generate cash flows, as well as the level of capital expenditure it is expected to incur over the next couple of years, which will result in how much money goes to you.
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What is free cash flow?
Continental’s free cash flow (FCF) is the level of cash flow the business generates from its operational activities, after it reinvests in the company as capital expenditure. This type of expense is needed for Continental to continue to grow, or at least, maintain its current operations.
There are two methods I will use to evaluate the quality of Continental’s FCF: firstly, I will measure its FCF yield relative to the market index yield; secondly, I will examine whether its operating cash flow will continue to grow into the future, which will give us a sense of sustainability.
Free Cash Flow = Operating Cash Flows – Net Capital Expenditure
Free Cash Flow Yield = Free Cash Flow / Enterprise Value
where Enterprise Value = Market Capitalisation + Net Debt
Along with a positive operating cash flow, Continental also generates a positive free cash flow. However, the yield of 2.25% is not sufficient to compensate for the level of risk investors are taking on. This is because Continental’s yield is well-below the market yield, in addition to serving higher risk compared to the well-diversified market index.
Does Continental have a favourable cash flow trend?
Does CON’s future look brighter in terms of its ability to generate higher operating cash flows? This can be estimated by examining the trend of the company’s operating cash flow moving forward. In the next couple of years, the company is expected to grow its cash from operations at a double-digit rate of 12%, ramping up from its current levels of €5.0b to €5.6b in two years’ time. Furthermore, breaking down growth into a year on year basis, CON is able to increase its growth rate each year, from 1.1% next year, to 10% in the following year. The overall future outlook seems buoyant if CON can maintain its levels of capital expenditure as well.
Next Steps:
Although its positive operating cash flow, and high future growth, is appealing, the low free cash flow yield is unattractive. This is because you would be better compensated in terms of cash yield, by investing in the market index, as well as take on lower diversification risk. However, cash is only one aspect of investing. Now you know to keep cash flows in mind, I suggest you continue to research Continental to get a more holistic view of the company by looking at: