In Part 1, we went through the basics of free cash flow and how to manually calculate free cash flow from financial statements.
Today I’d like to share with you how you can use free cash flow in different ways to value a company.
Seth Klarman mentions 3 ways in which investors make money from stocks, free cash flow being one of them:
Investors in a stock thus expect to profit in at least one of three possible ways: from free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends; from an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price; or by a narrowing of the gap between share price and underlying business value – Seth Klarman from Margin Of Safety
As we have seen in Part 1 free cash flow measures how much cash a company has at the end of an accounting period after paying for reinvestments into the business vital to its operations. These vital reinvestments are called capital expenditure (capex).
Examples of capital expenditure include plant, property and equipment – tangible assets abbreviated to PPE on the balance sheet or notes to the accounts.
One example of intangible capital expenditure is the costs associated with repairing plant, property and equipment.
Its clear that if a business fails to spend money on assets vital to its operations, it will have a hard time competing with businesses who do. The expectation is that if you spend money on assets, the value of the business will grow in the future because assets are responsible for generating earnings which will reflect in higher share prices or as dividends the way Klarman describes.
The good thing about that, is that you can scrutinise how well or how poorly management are generating earnings from assets by using a ratio called Return on Assets (ROA).
If cash is the life blood of a business, then capital expenditure is its nourishment.
How To Find Free Cash Flow Data For Stocks
The Price/Free Cash Flow metric is the most widely regarded metric that uses free cash flow to value a company. It is loved by institutional and private investors alike for one simple reason – in contrast to earnings, free cash flow is harder for managements to manipulate for their own ends whereas earnings can be manipulated by the use of aggressive accounting.
Here is the formula for the price/free cash flow metric:
You can use both Morningstar or ADVFN to obtain the metrics and ratios of company’s you’re interested in.
For example with ADVFN, click the ‘financials’ tab at the top of their website and enter the name of your stock in the search box. In the example below I’ve used Apple (AAPL):
The price/free cash flow and additional free cash flow data for US companies can be found by scrolling down to a section called ‘profitability’:
|working capital per share||23.19||22.28||22.88||18.31||20.35|
|cash flow per share||5.97||9.97||16.42||29.85||47.92|
|free cash flow per share||9.2||9.94||17.29||32.1||41.12|
|Return on Stock Equity (ROE)||23||26||29.3||33.8||35.3|
|Return on Capital Invested (ROCI)||23||26||29.3||33.8||35.3|
|Return on Assets (ROA)||12.2||17.3||18.6||22.3||23.7|
|price/cash flow ratio||19||18.6||17.3||12.8||13.9|
|price/free cash flow ratio||12.4||18.6||16.4||11.9||16.2|
|sales per employee||1014969||1165897||1320344||1710095||2149835|
This table is awesome at allowing you a quick glance at pertinent ratios/metrics in one place.
If you click on annual reports and scroll down halfway through the data, you will find additional free cash flow data:
|All amounts in Millions of US Dollars||2008||2009||2010||2011||2012|
|free cash flow||8,177||8,946||15,836||29,833||38,616|
How You Can Use Free Cash Flow To Value A Stock
There are two principle methods that are used to value stocks using free cash flow:
- Compare a stock’s current Price/Free Cash Flow with that of the general market – to do this with Apple (AAPL), you would compare Apple’s current Price/Free Cash Flow with that of the S&P500 with a view to ensuring that Apple’s Price/Free Cash Flow is lower than the S&P 500’s. These two sets of cash flow data are available on most financial websites.
- Compare a stocks current Price/ Free Cash Flow with that of it’s 5 or 10 year average – this is my preferred option because it focusses on the company without regard to what the general market is doing. At this time, there are no financial websites that provide such comparisons for free but you could easily copy and paste the profitability information above or directly from a financial website into excel and calculate it using a formula.
To value a stock with proper due diligence takes a lot of reading. Value ratios such as Price/Free Cash Flow can act as a filter by eliminating stocks that do not stack up to value investing criteria. They are a big time saver.
If you want to value stocks using ratios and metrics then Price/Free Cash Flow is an awesome one to use because free cash flow is harder for managements to manipulate.
Ratios ought not to be used in isolation, here are some posts on additional ratios that will help you to direct you research in the right way:
- The PE (Price To Earnings) Ratio
- How To Value A Company; The Lazy Investor’s Guide
- How To Use ADVFN To Invest Like Ben Graham And Walter Schloss