How to Use Free-Cash Flow to Value Stocks

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There a number of well-known metrics investors use to determine whether or not a stock should be purchased. Price-to-earnings analysis, dividend discount models, and modern portfolio theory are all commonly used by investors to place a value on a prospective stock. But there’s another metric that’s slowly taking over as the preferred method for valuing a stock – free cash flow.

Evaluating a company based on how much free cash flow (FCF) is available often gives investors a better representation of how the company is actually managing its finances and what investments the company is making into its future growth. Rather than just looking at basic P/E and PEG ratios, investors use the free-cash-flow yield in place of the price-to-earnings ratio to value a stock.

The basics of FCF valuation

Free cash flow is a measurement of how much money a company has left over after all expenses and capital expenditures (funds that are reinvested) are calculated. There are several ways FCF can be calculated but the simplest is to subtract capital expenditures from cash flow from operating activities (earnings before interest and taxes plus depreciation minus taxes).

To get the FCF yield you only need to divide FCF per share by the current price per share. The higher the ratio, the more attractive the investment and vice versa. Because FCF analysis takes into account capital expenditures and other operating costs, many investors prefer it over earnings since it paints a more accurate picture of a company’s finances.

Positive FCF means that the company has room for future growth and the ability to reinvest profits back into the business. A negative FCF means that the company doesn’t have enough income to manage its current expenses. However, investors should note that many fast-growing companies may start out with a negative cash flow until the company grows large enough to take advantage of things like economies of scale.

FCF is also harder to manipulate. Earnings can be manipulated more easily through things like share buyback programs which lower the number of total outstanding shares and thus make earnings per share seem higher. For these reasons, investors tend to trust FCF analysis more than EPS analysis.

Final considerations

As with any metrics used to value a stock, investors shouldn’t rely on just one method. While FCF helps investors get a better and more accurate reading of a company’s fundamental performance, it still works best when used in combination with other valuation methods. While a high FCF yield is usually a sign of strength for a company, growth stocks may not have a high FCF yield – it may even be negative. Investors should keep in mind what metrics are most important when evaluating a potential investment.