Price to free cash flow is an equity valuation metric that compares a company’s stock price to its free cash flow.
This ratio is mainly used to determine how much liquidity (cash) remains after subtracting operating costs and capital expenditures.
It’s considered more reliable than other metrics, making it important for investors and professionals. Let’s delve deeper.
What is Price to free cash flow
P/FCF is calculated by comparing two equity metrics: market capitalization and free cash flow.
In simpler terms, divide the company’s market capitalization by its free cash flow to obtain the Price to free cash flow ratio. Alternatively, compare the capital value per share to the free cash flow per share.
This metric is more accurate and preferable to price-to-cash-flow and price-to-earnings ratios.
Price-to-cash-flow ratios only include operating cash flow, but in this metric, free cash flow is calculated by subtracting capital expenditures from operating cash flow.
Therefore, this ratio provides a more accurate indication of how much liquidity a company has left for non-asset growth.
How to Calculate Price to free cash flow Ratio
To calculate the P/FCF ratio, you should determine two metrics for the company.
1. Market Capitalization: Market capitalization is the overall value of the company. To calculate this, multiply the company’s total outstanding shares by the stock price.
Formula: Outstanding shares × share price.
Example: If a company has 100 million outstanding shares and a per-share price of $20, the market cap is 2 billion.
Market Cap = 100M × $20 = $2B
2. Free Cash Flow: This is calculated by subtracting operating expenses and capital expenditures from the cash generated by the company. Since most companies allocate a significant portion of cash for capital expenditures (capex) to grow fixed assets, subtracting these figures from operating cash will reflect a more accurate value.
Formula:
Free cash flow = operating cash flow – capital expenditures
Another one:
free cash flow = total generated cash by the company – operating expenses – capital expenditures.
Operating cash flow is found in the operating section of the cash flow statement.
Example for, Let’s consider Amazon in the year 2022.
Given data:
Outstanding Shares of Amazon = 10,189 million
Share Value of the company = $83
Operating Cash Flow = $46,752 million
Capital Expenditures = $34,650 million
Now, we calculate:
\text{Market Cap} = 10,189 \, \text{million} \times \$83\text{Market Cap} = \$846,287 \, \text{million}
\text{Free Cash Flow} = \$46,752 \, \text{million} - \$34,650 \, \text{million}
\text{Free Cash Flow} = \$12,102 \, \text{million}
Now, the P/FCF ratio is calculated as:
\text{P/FCF ratio} = \frac{\text{Market Cap}}{\text{Free Cash Flow}}\text{P/FCF ratio} = \frac{\$846,287 \, \text{million}}{\$12,102 \, \text{million}}
\text{P/FCF ratio} \approx 69.99
The value of this ratio, approximately 69.99, indicates that investors are willing to pay around $69.99 for every dollar generated by the company.
Compare the Ratio with Peer Industry
The Price to free cash flow ratio helps determine whether a share is undervalued or overvalued. To assess this, compare the ratio with other companies in the same industry. This provides insights into how cash flow performs.
If a company’s ratio is lower than others in the same industry, it suggests that the company’s share value is comparatively low, and it is generating a high cash flow. Investors often favor such companies for investment.
Conversely, if a company’s ratio is higher than its peers, it indicates that the stock price is overvalued, and the cash flow generated is relatively low. Management should address this promptly, as it means investors would have to pay a premium.
It’s crucial to note that different industries have different valuations. For instance, the banking sector typically has a higher ratio compared to the manufacturing industry. Never rely solely on a single ratio to determine a company’s financial position; it’s best to use other ratios such as P/E, P/S, and P/B ratios.
Importance of the Price to free cash flow Ratio
The P/FCF ratio is useful for investors to ascertain the actual position of the company. It indicates how much cash is left after subtracting operating expenses and capital expenditures.
P/FCF is more reliable compared to other ratios like price-to-cash-flow, price-to-sales, and price-to-earnings. As it accounts for capital expenditures, P/FCF becomes more accurate for investors to gauge the company’s strength in generating cash.
Furthermore, it reveals how much surplus money a company has for investing in non-fixed assets, buying back shares, and paying dividends.
An additional benefit is that P/FCF cannot be easily manipulated by accounting methods, unlike price-to-earnings ratios.
Generally, investors favor undervalued shares with a low P/FCF ratio, indicating high free cash flow and a lower stock value comparatively. They tend to avoid high P/FCF ratios, which have high stock prices and low free cash flow, with a lower possibility of future increases.
Limitations of the Price to free cash flow Ratio
While the Price to free cash flow ratio is superior to others, it does have limitations. This ratio may not be suitable for all companies, such as startups or those reinvesting heavily in the business. Startups often invest heavily in assets initially, while some companies reinvest significantly in fixed assets to expand their operations.
Additionally, it does not consider the company’s debt, providing investors with an incomplete overview of the company’s financial structure.
Conclusion
In summary, the Price to free cash flow ratio is a valuable tool for comparing a company with others to assess its performance. I recommend using multiple cash flow ratios to gain a comprehensive understanding of the company’s actual position.
For a more in-depth analysis, refer to my article on the best cash flow ratios. It will provide a broader perspective for analyzing a company.