If you are currently a shareholder in Constellation Software Inc. (TSE:CSU), or considering investing in the stock, you need to examine how the business generates cash, and how it is reinvested. This difference directly flows down to how much the stock is worth. Operating in the industry, Constellation Software is currently valued at CA$20b. I’ve analysed below, the health and outlook of Constellation Software’s cash flow, which will help you understand the stock from a cash standpoint. Cash is an important concept to grasp as an investor, as it directly impacts the value of your shares and the future growth potential of your portfolio.
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What is free cash flow?
Constellation Software 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 Constellation Software’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
Constellation Software’s yield of 3.13% indicates its sub-standard capacity to generate cash, compared to the stock market index as a whole, accounting for the size differential. This means investors are taking on more concentrated risk on Constellation Software but are not being adequately rewarded for doing so.
Is Constellation Software’s yield sustainable?
Does Constellation Software’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, Constellation Software’s operating cash flows is expected to grow by a double-digit 42%, which is encouraging, should capital expenditure levels maintain at an appropriate level. Below is a table of Constellation Software’s operating cash flow in the past year, as well as the anticipated level going forward.| Current | +1 year | +2 year | |
|---|---|---|---|
| Operating Cash Flow (OCF) | US$616m | US$720m | US$873m |
| OCF Growth Year-On-Year | 17% | 21% | |
| OCF Growth From Current Year | 42% |
Next Steps:
Given a low free cash flow yield, on the basis of cash, Constellation Software becomes a less appealing investment. 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. 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 Constellation Software to get a better picture of the company by looking at:
- Valuation: What is CSU 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 CSU 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 Constellation Software’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 editorial-team@simplywallst.com.