Free Cash Flow (FCF) – The cash left after making investments in capital assets
The price-to-free cash flow ratio (P/FCF) is a valuation method used to compare a company’s current market share price to its per-share free cash flow.
Free cash flow (FCF) measures a company’s financial performance. It measures how much cash a business can generate after accounting for capital expenditures such as buildings or equipment. In other words, FCF measures a company’s ability to produce what investors care most about: cash that’s available to be distributed in a discretionary way.
FCF is calculated with the formula below:
Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures
Most information needed to compute a company’s FCF is on the cash flow statement. As an example, let Company A have $22 million dollars of cash from its business operations and $6.5 million dollars used for capital expenditures, net of changes in working capital. Company A’s FCF is then computed as:
FCF = $22 – $6.5 = $15.5m
Free cash flow relies heavily on the state of a company’s cash from operations (CFO). The cash from operations deals with the cash inflows and outflows directly related to the company’s primary activity: selling a good or service. Cash from operations is heavily influenced by the company’s net income (excluding depreciation).
The presence of free cash flow indicates that a company has cash to expand, develop new products, buy back stock, pay dividends, or reduce its debt. High or rising free cash flow is often a sign of a healthy and growing company that is thriving in its current environment.
For investors, free cash flow measures a company’s ability to generate cash, which is a fundamental basis for stock pricing. This is why some people value free cash flow more than just about any other financial measure out there, including earnings per share or book value per share.
Investors should understand that companies can manipulate their free cash flow by lengthening the time they take to pay the bills (preserving their cash), shortening the time it takes to collect what’s owed to them (accelerating the receipt of cash), and putting off buying inventory (preserving cash). Also, companies have some leeway about what items are or are not considered capital expenditures, and the investor should be aware of this when comparing the free cash flow of different companies.
Since FCF has a direct impact on the worth of a company, investors should hunt for companies that have high or improving free cash flow but low correlated market share prices.
Low P/FCF ratios typically can mean the shares of the underlying company are undervalued. Thus, the lower the P/FCF ratio, the “cheaper” and better value the stock remains.
The best, most successful investors are continually learning and continually honing and expanding their skills at making money in the financial markets.
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