Two important questions to ask before you buy Technology One Limited (ASX:TNE) is, how it makes money and how it spends its cash. What is left after investment, determines the value of the stock since this cash flow technically belongs to investors of the company. I will take you through TNE’s cash flow health and the risk-return concept based on the stock’s cash flow yield, using the most recent financial data. This will help you think about the company from a cash perspective, which is a crucial factor to investing.
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What is free cash flow?
Technology One’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 Technology One to continue to grow, or at least, maintain its current operations.
There are two methods I will use to evaluate the quality of Technology One’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, Technology One also generates a positive free cash flow. However, the yield of 2.64% is not sufficient to compensate for the level of risk investors are taking on. This is because Technology One’s yield is well-below the market yield, in addition to serving higher risk compared to the well-diversified market index.
What’s the cash flow outlook for Technology One?
Another important consideration is whether this return is likely to be maintained over the next couple of years. We can gauge this by looking at TNE’s expected operating cash flows. In the next couple of years, the company is expected to grow its cash from operations at a double-digit rate of 90%, ramping up from its current levels of AU$49m to AU$92m in three years’ time. Although this seems impressive, breaking down into year-on-year growth rates, TNE’s operating cash flow growth is expected to decline from a rate of 40% in the upcoming year, to 19% by the end of the third year. But the overall future outlook seems buoyant if TNE can maintain its levels of capital expenditure as well.
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 Technology One to get a more holistic view of the company by looking at:
- Valuation: What is TNE 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 TNE 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 Technology One’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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.