Price to free cash flow (P/FCF) is an essential equity valuation metric that compares a company’s per-share market price to its free cash flow (FCF). This metric provides a more precise measure as it uses free cash flow, which subtracts capital expenditures (CAPEX) from a company’s total operating cash flow, thereby offering a clear picture of the actual cash flow available for non-asset-related growth.
Companies use this metric to make informed growth decisions and maintain optimal free cash flow levels.
Key Insights
- Price to Free Cash Flow: It indicates a company’s capability to sustain operations, calculated by dividing its market capitalization by free cash flow values.
- Undervalued vs. Overvalued: A lower P/FCF value suggests that the company is undervalued, making its stock relatively affordable. Conversely, a higher value suggests overvaluation.
- Comparative Uses: This ratio can be used to evaluate a company’s stock value relative to its cash management practices over time.
Understanding the Price to Free Cash Flow Ratio
A company’s free cash flow is a crucial indicator of its ability to generate new revenues. As such, the price to free cash flow metric is incredibly vital in stock pricing.
The formula for calculating Price to FCF is:
\text{Price to FCF} = \frac{\text{Market Capitalization}}{\text{Free Cash Flow}}
Example: If a company has $100 million in total operating cash flow and $50 million in capital expenditures, its free cash flow total will be $50 million. Should the company’s market capitalization be $1 billion, the ratio is 20, indicating the stock trades at 20 times its free cash flow.
At times, you may encounter a company with more free cash flows than its market cap or one where both are nearly equal. For instance, a market cap of $102 million and free cash flows of $110 million results in a ratio of 0.93. While this might be typical for certain industries, significant deviations should prompt further investigation to uncover potential financial issues or market undervaluation.
Using the Price to Free Cash Flow Ratio
As a valuation metric, lower P/FCF numbers typically reflect that a company is undervalued, rendering its stock relatively affordable in relation to its free cash flow. Conversely, higher P/FCF values may signify overvaluation.
Value investors tend to prefer companies with low or decreasing P/FCF values. Such companies often have high or increasing free cash flows paired with comparatively low stock prices within the same industry. However, it is crucial to compare a company’s P/FCF against past ratios, competitors, or industry norms for the metric to hold meaning.
Similarly, investors usually avoid companies with high P/FCF values, which might suggest that the stock is overpriced relative to its free cash flow. Thus, the lower the P/FCF ratio, the more a company’s stock is viewed as a better bargain or value.
It is also advisable to analyze the P/FCF ratio over a long-term period to observe if the company’s value in terms of cash flow to share price is improving or deteriorating.
Beware of Manipulated Ratios
The P/FCF ratio can be manipulated by management actions such as delaying inventory purchases or deferring accounts payable payments. Therefore, analyzing a company’s overall financial health across several reporting periods offers a broader perspective of its financial integrity and cash usage.
Evaluating a Good Price to Free Cash Flow Ratio
A “good” P/FCF ratio suggests the stock is undervalued. Its relative goodness can be determined by comparing the ratio with those of similar companies within the same industry. Generally, the lower the ratio, the cheaper the stock.
When High Price to Free Cash Flow Ratios Matter
A higher than normal P/FCF — for the industry average — can indicate potential overvaluation of a company’s stock.
Differentiating Price to Cash Flow and Free Cash Flow
Price to cash flow ratio accounts for all available cash, while price to free cash flow removes expenses like CAPEX, working capital, and dividends, thus providing a refined reflection of available cash post-obligations relative to stock price. Consequently, it serves as a stronger indicator of a business’s operational capability.
Related Terms: Price to Cash Flow, Free Cash Flow, Market Capitalization, Valuation Metrics, Operating Cash Flow
