Free Cash Flow Strips Away Veneer
The price/earnings ratio is the best known measurement of stock valuation, and it is one of the most effective. But it’s not the only one.
Earnings reflect a lot of noncash adjustments. Cash-flow metrics look past such items, focusing on a company’s ability to generate cash. The price/free-cash-flow ratio, among the most effective stock-picking metrics in our Quadrix® rating system, values companies relative to the cash they generate after expenses, dividends, and capital spending.
Cash flow from operating activities adds such noncash costs as depreciation and amortization back to net income and accounts for changes in operating assets and liabilities. To derive free cash flow, dividends and capital spending are subtracted from operating cash flow.
Free cash flow shows how much money a company has left after meeting substantially all of its obligations. The story isn’t always pleasant. In the last 12 months, 12% of the nonfinancial and nonutility stocks in the S&P 1500 Index delivered negative free cash flow.
In rolling 12-month periods since 1994, the cheapest one-fifth of S&P 1500 Index stocks as measured by the price/free-cash-flow ratio averaged a return of 17.1%, versus 16.0% for the top one-fifth based on Quadrix Value scores and 12.6% for the average stock in the index.
For price/free-cash-flow ratios on all nonfinancial and nonutility stocks in the S&P 1500 Index, visit www.DowTheory.com/Go/FCF. For a list of stocks with modest price/free- cash-flow ratios, see the linked table.
Few of the Forecasts’ recommended stocks have extremely low price/cash flow ratios, which should not come as a surprise. We don’t focus on deep-value picks, instead seeking growth at a good price.
Among our recommended stocks with very high scores for price/free cash flow (equating to very low P/FCF ratios) are insurer Aflac ($45; AFL) and retailer GameStop ($18; GME). Aflac shares trade at just 3.7 times trailing 12-month free cash flow despite the stock’s 9% bounce from July lows. Over the last two years, Aflac has paid out $958 million on dividends and spent $1.45 billion buying back its own stock. Shares of GameStop, despite weaker-than-expected sales of video games nationwide and the threat of new competition in the used-game market, have managed to rise 7% from a February low. GameStop earned $0.26 per share in the July quarter, up 13% but a penny below the consensus. Revenue rose 3% to $1.80 billion on market-share gains in new video-game software. Same-store sales rose 0.9%. Aflac is a Focus List Buy and a Long-Term Buy. GameStop is rated Buy.