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The price/free cash flow ratio indicates whether a company is ready to reward impatient shareholders.
By Hyunsoo Lim and Segun Olakoyenikan, edited by William Baldwin
You know Tesla is expensive: The stock is trading at 63 times its earnings over the past year, and did you know its cash flow multiple is even more insane, at 10 times its P/E ratio?
The metric in question is stock price divided by free cash flow, which compares the market value of the common stock to the free cash a company generates. A low ratio suggests the company is undervalued.
The P/FCF ratio is similar to the price-to-earnings ratio. However, free cash is very different from earnings. A company may report large earnings despite not being able to accumulate cash. The money the company makes is put back into the business to replace aging equipment or expand. Such a company may be reasonably priced from a P/E perspective, but look quite expensive in terms of P/FCF.
Tesla made $12 billion in profits for the 12 months ending June 30, which isn’t bad. But when the company finished its capital expenditures, it had a lot less money left in the coffers. Tesla is putting much of its profits into new factories, artificial intelligence, and its inventory of leased vehicles. It doesn’t pay dividends. This stock is a pure growth stock. Kill two birds with one stone.
Celanese is cheap, in stark contrast, both in terms of profits and cash generated from operations. The company’s profits are the kind you can take to the bank, meaning they’re shareholder-friendly and are used to pay dividends, buy back shares, and pay down debt. Growth isn’t exciting. Instead, shareholders have a bird in their hand.
What is free cash flow? The simplest analysis is to add depreciation to net income and subtract capital expenditures. If the depreciation expense used to calculate net income is greater than the amount spent on adding assets, then free cash flow will be higher than net income. This is the type of company that is ready to pay a good dividend.
A stricter definition starts with the “cash flow from operations” number on your financial statements. To get cash flow from operations, accountants add to net income any non-cash expenses, such as depreciation of assets, amortization of goodwill, and documentation costs for employee options. They then consider changes in working capital that absorb or release cash. An increase in accounts receivable (because customers are taking longer to send checks) reduces cash flow from operations, while an increase in accounts payable increases cash flow.
Now subtract capital expenditures, which are a mix of things necessary to keep existing customers from abandoning and things that can generate growth. In the former category, it’s replacing outdated tools, past hit movies, and dwindling oil wells. The latter is part of Tesla’s new “gigafactory.” In the most recent quarter, Tesla generated $3.8 billion in cash from operations, but spent $5 billion on property, factory, and equipment. It borrowed to stay in business.
Annual report cash flow statements generally do not distinguish between maintain and expand; they usually just report the total amount of capital expenditures. Investors are left to subtract the lump sum amount of capital expenditures and use the resulting free cash flow figure, along with many other clues (such as earnings), to determine whether to buy a growing business or a fast-growing business to maintain the status quo.
Like the P/E ratio, the P/FCF ratio has limitations: The ratio can spike or become meaningless when the denominator is small or negative. Different data sources define variables differently. The ratio can be highly volatile. According to Morningstar calculations, Netflix’s price/cash flow ratio was 417 in 2021 and 36 in 2023.
This table shows cheap companies from the YCharts database that have low cash flow multiples and low earnings multiples: Then we have expensive companies with high P/FCF, which is significantly higher than their P/E.
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