It’s the mantra every business owner lives by, and one that every investor should note. Cash is king.
Unlike earnings, which can be adjusted with accounting tactics, cash flow – particularly free cash flow – reveals what a business actually generates and retains after it pays its taxes, interest, debt, capital investments and any other obligations.
It’s the true cash available to reinvest, acquire, or return to shareholders via dividends and buybacks. That’s why strong, consistent free cash flow is a hallmark of high-quality companies.
Earnings can lie. Cash flow doesn’t. This distinction matters. Investors learned it the hard way with Enron, which reported 13 per cent earnings growth annually from 1996 to 2000 but posted negative free cash flow every year during that period, burning through over $US5 billion before collapsing under the weight of too much debt and fabricated accounts.
Since late 2017, markets have faced trade wars, a pandemic, European conflicts, the fastest rate hikes in 40 years, and multiple bear (or near-bear) markets.
Yet investors who stayed the course more than doubled their money – thanks in large part to strong free cash flow growth among global companies, especially in sectors such as technology, now a much larger part of equity indices.
Bloomberg data shows the MSCI World Index’s free cash flow per share grew 5.3 per cent annually over 15 years, accelerating to 11 per cent annually in the past five. Over the same 15 years, the index returned roughly 9 per cent annually.
This signals something important: investors are willing to pay a premium for companies that consistently grow cash flows. And by that metric, global equities are far from bubble territory; if companies keep delivering on cash, there’s still room for long-term wealth creation.
One big driver of this resilience is the shift towards tech. Tech-related companies now make up more than 40 per cent of the global index, up from just 10 per cent 30 years ago.
These firms grow faster and more predictably than cyclical sectors such as manufacturing or financials because they’re “asset light”, relying on software, intellectual property, and talent rather than heavy equipment. Their lower capital costs translate into greater ability to convert profits into real, bankable cash.
In fact, their pre-tax profit margins are nearly double the average of non-tech companies.
It’s no surprise, then, that tech now dominates global free cash flow rankings.
Even with indices at or near record highs, global equities still trade within a reasonable range – around 10 per cent above or below fair value – when measured through the lens of free cash flow.
This reframes how we value the market. While broad indices may appear expensive using old-school metrics such as price-to-earnings or price-to-book ratio, they look more reasonable when assessed through the lens of free cash flow.
These businesses aren’t cheap but given the quality and cash they generate, they’re not as overvalued as many assume.
One of the clearest examples of cash flow’s power is fashion house Hermes.
Back in 2010, rival LVMH Moët Hennessy Louis Vuitton quietly acquired a 14.2 per cent stake in Hermes. Within a year, that grew to 22.6 per cent – a move widely seen as a takeover attempt. Two years later, LVMH was forced to divest this stake to its shareholders and abandon any control ambitions.
Had LVMH succeeded in buying the company outright, paying a 33 per cent premium at the time, the deal might have cost around €22 billion. Since then, Hermes has generated over €24 billion in free cash flow and expects another €5 billion next year.
Simply put, Hermes has earned back its acquisition price – in pure cash – within just 15 years.
That’s remarkable for a 150-year-old brand, especially considering the headwinds: luxury crackdowns in China, global tariffs, soaring interest rates, wars, and more than 10 sharp draw-downs in its share price. Yet through it all, Hermes compounded free cash flow at nearly 15 per cent annually, delivering real long-term wealth beyond market noise.
Hermes may be exceptional, but it’s far from unique. Around one-third of S&P 500 companies have compounded free cash flow by 10 per cent plus annually in the past decade.
Individual investors can’t buy entire companies such as Hermes, but the principle holds.
Public markets offer access to hundreds of companies with similar traits: proven operators with resilient, growing cash flows that endure through market cycles. These businesses span a range of sectors and geographies, and include well-known names such as Microsoft, Accenture, Mastercard, Costco, Novo Nordisk, Richemont, Ferrari, and Australia’s REA Group.
Short-term price swings driven by headlines and sentiment often mask fundamentals such as free cash flow. But over time, the fundamentals matter – and companies that consistently generate and compound cash tend to prevail.
Approach portfolio construction the way a founder would approach buying a business – prizing durable cash flow above all else – is a sure way to build enduring wealth.
