Seeking Companies That Generate Free Cash Flow
Cash generation is “king” for many investors selecting stocks. Earnings, dividends and asset values may be important factors, but it is ultimately a company’s ability to generate cash that fuels the growth in these factors. Strong cash flow allows a company to increase dividends, develop new products, enter new markets, pay off liabilities, buy back shares and even become an acquisition target.
Earnings and earnings multiples dominate standard measures of firm performance and stock price valuation. However, slight accounting differences make it difficult to track earnings over time or between firms. Actual cash flow is free from many of these problems of comparability across firms and consistency over time.
Traditional Cash Flow Measures
Cash flow has traditionally been calculated by adding noncash expenses back to earnings after taxes and subtracting dividend payments. Noncash expenses such as depreciation, amortization and depletion are taxable expenses that appear on the income statement but require no cash outlays. They represent the accountant’s attempt to measure the reduction of the book value of assets as the assets are depleted. While dividends are a discretionary item, they are a real cash outlay that is not tax deductible and is not reflected in earnings. Subtracting dividends and adding back noncash expenses to earnings provides an estimate of cash flow.
This widely used cash flow estimate has many weaknesses that arise out of the use of accrual accounting for the calculation of the income statement. Accrual accounting attempts to match expenses to revenues when the revenues can be expected to be recognized. For example, cash used to build up inventory will not be reflected as an expense on the income statement until the inventory is sold. But even then, the recognition of this inventory cost may vary from firm to firm if one company uses a last in, first out (LIFO) method to measure the cost of inventory sold while another firm uses a first in, first out (FIFO) method. Higher sales may not translate into higher cash flow if accounts receivable are allowed to grow faster than sales. Prepaid expenses such as income taxes and software development costs may not flow through the income statement when the costs are incurred. On the other hand, much like a personal checkbook, cash accounting tracks cash inflows and outflows directly when they actually occur.
Accrual accounting introduces many interpretations and estimates by management into the financial statements. Decisions regarding the capitalization of expenses, the recognition of revenue, the creation of reserves against losses and write-off of assets are examples of just a few of the factors that may vary from firm to firm. Many of these issues are factors that relate to the “quality” of a firm’s earnings. Since the traditional cash flow estimate is tied directly to earnings with few adjustments, it represents a weak estimate of the firm’s actual cash flow.
Statement of Cash Flow
Companies have been required to provide a statement of cash flow since 1987. The purpose of the statement is to disclose information about the events that affected cash during an accounting period. The statement looks at the changes in the levels of cash directly, eliminating many of the weaknesses with the traditional estimate of cash flow.
The statement divides company uses and sources of cash into three primary segments—operating, investing and financing cash flows.
The operating cash flow segment is designed to measure a company’s ability to generate cash from day-to-day operations as it provides goods and services to its customers. It considers factors such as cash from the collection of accounts receivable, the cash incurred to produce any goods or services, payments made to suppliers, labor costs, taxes and interest payments. A positive cash flow from operations implies that a firm was able to generate enough cash from continuing operations without the need for additional funds. A negative cash flow from operations indicates that additional cash inflows were required for day-to-day operations of the firm.
The investing segment of the cash flow statement attempts to capture the company’s investment in the long-term capital of the firm. Factors recorded in this segment can include purchases of property, plant and equipment; investment or sale of marketable securities; and investments or divestitures in unconsolidated subsidiaries. Negative cash flow from investing activities indicates that the company made additional long-term investments in the company’s long-term assets or outside investments. A positive cash flow from investing activities indicates a divestiture or sale of the long-term assets of the firm.
The financing segment of the cash flow statement examines how the company finances its endeavors and how it rewards its shareholders through dividend payments. Factors such as cash received from the issuance of new shares of stock or debt, payment of dividends to stockholders and the cash used to repurchase stocks to retire debt are summarized in this segment. Note that interest payments are considered part of normal operational expenses and are factored into the operating segment, not the financing segment, of the cash flow statement. The financial segment also often examines the impact of foreign currency translation.
Free Cash Flow
Ideally, a company should not only cover the costs of producing its goods and services but also produce excess cash flow for its shareholders. Cash flow from operations represents a good starting point for this type of analysis. However, beyond current production, a growing company must reinvest its cash to maintain its operations and expand. While management may neglect capital expenditures in the short term, there are fundamental negative long-term growth implications to such neglect. Optimally, one would use the capital expenditures required to sustain the health of the company, but that is a highly subjective figure that will not appear as a line item on the financial statement. Actual capital expenditures serve as a proxy measure of this sustained investment into the company’s present and future operation.
Free cash flow refines the measure of cash flow from operations by considering capital expenditures and dividend payments to shareholders. While you can argue that dividend payments are not required, they are expected by shareholders and they are paid in cash, so they must be subtracted from cash flow to calculate a free cash flow figure. Free cash flow is calculated by subtracting capital expenditures and dividend payments from cash flow from operations.
This free cash flow figure is considered to be excess cash flow that the company can use as it deems most beneficial. With strong free cash flow, debt can be retired, new products developed, stock can be repurchased and dividend payments can be increased.
The Screening Criteria
A screen for positive and consistent free cash flow is a good starting point for the investor scanning for firms on a cash flow basis. The first screen requires a market capitalization greater than or equal to $50 million. This restriction excludes small stocks with poor trading liquidity.
The next screening factor excludes financial firms. The cash flow calculation in AAII’s Stock Investor Pro calculates free cash flow by subtracting capital expenditures and dividends from operating cash flow on the cash flow statement. Financials do not typically have large expenditures in brick-and-mortar property, plant and equipment. However, they make significant investments in marketable securities, which are not considered in the standard free cash flow calculation. When looking at the cash flow of a financial firm, it would be best to examine total cash flow figures from the statement of cash flows.
The screen then requires positive free cash flow for each of the last five fiscal years and the most recent 12 months. Ideally, a company would always have positive and increasing free cash flow. However, cyclical firms and companies with long development and construction cycles may have periods of slow sales, inventory build-up and strong capital expenditures that occur over the normal course of business. A firm such as Boeing
Screening for Reasonable Value
Higher free cash flows should translate into higher stock prices. The ratio of stock price to free cash flow per share is a method by which to judge value. Comparing a company’s price-to-free-cash-flow ratio to those of other companies, industry norms and historical averages provides some feel for relative value much like the traditional price-earnings ratio. Firms with low price-to-free-cash-flow ratios may represent neglected firms at attractive prices. Our screen looks for companies with a price-to-free-cash-flow ratio below the median for their industry and below the company’s own five-year average.
The analysis of a company’s cash flow is a very revealing study of a firm. The free cash flow measure highlights the effective management of overall company operations including factors such as sales, inventory control, production and employee costs, accounts receivable management, interest payment levels, product development and capital expenditures. Screening for firms with attractive levels of price to free cash flow provides a useful technique to highlight more mature value stocks worthy of further study. However, as with all preliminary screens, a study of the annual report and an understanding of the company, its products and its industry are required.
Stocks Passing the Price-to-Free-Cash-Flow Screen (Ranked by Lowest Price-to-Free-Cash-Flow Ratio)
The 30 companies with the lowest price-to-free-cash-flow ratio are shown in the passing companies table below. Our Price-to-Free-Cash-Flow screening model has shown impressive long-term performance, with an average annual gain since 1998 of 17.2%, versus 5.9% for the S&P 500 index over the same period.
The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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