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Two important questions to ask before you buy Toll Brothers, Inc. (NYSE:TOL) is, how it makes money and how it spends its cash. After investment, what’s left over is what belongs to you, the investor. This also determines how much the stock is worth. Today we will examine TOL’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.
What is free cash flow?
Toll Brothers generates cash through its day-to-day business, which needs to be reinvested into the company in order for it to continue operating. What remains after this expenditure, is known as its free cash flow, or FCF, for short.
There are two methods I will use to evaluate the quality of Toll Brothers’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, Toll Brothers also generates a positive free cash flow. However, the yield of 3.5% is not sufficient to compensate for the level of risk investors are taking on. This is because Toll Brothers’s yield is well-below the market yield, in addition to serving higher risk compared to the well-diversified market index.
Does Toll Brothers have a favourable cash flow trend?
Does TOL’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 29%, ramping up from its current levels of US$602m to US$776m in three years’ time. Furthermore, breaking down growth into a year on year basis, TOL is able to increase its growth rate each year, from -15% in the upcoming year, to 15% by the end of the third year. The overall picture seems encouraging, should capital expenditure levels maintain at an appropriate level.
Low free cash flow yield means you are not currently well-compensated for the risk you’re taking on by holding onto Toll Brothers relative to a well-diversified market index. However, the high growth in operating cash flow may change the tides in the future. Keep in mind that cash is only one aspect of investment analysis and there are other important fundamentals to assess. I recommend you continue to research Toll Brothers to get a more holistic view of the company by looking at:
- Valuation: What is TOL worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether TOL is currently mispriced by the market.
- Management Team: An experienced management team on the helm increases our confidence in the business – take a look at who sits on Toll Brothers’s board and the CEO’s back ground.
- Other High-Performing Stocks: If you believe you should cushion your portfolio with something less risky, scroll through our free list of these great stocks here.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. On rare occasion, data errors may occur. Thank you for reading.