Oftentimes when evaluating stocks you hear different terms used like price to earnings ratio (PE ratio), price to sales ratio (PS ratio), or price to free cash flow. These, and several other metrics, are all different ways to help investors get a look into whether a company is a good value or not. Here is a quick look into how one of these valuations work.
What is free cash flow?
Free cash flow (FCF) is the cash a company has left over after it pays it's operating expenses, and it's capital expenditures (CapEx). For instance, after payroll, rent, taxes, and any other capital expenditure like property and equipment, the money left over is free cash flow (FCF). This amount tells you the cash available that the company has to pay off debt, pay dividends to shareholders, fund a stock repurchase program, or put back into the growth of the company in other ways.
This measurement helps determine how well the company can generate profit and gives better insight into the financials of the company, therefore helping to determine if it is a good investment.
Price to free cash flow (FCF)
Price to free cash flow is an equity (aka, stock) valuation metric that compares a company's per-share market price to its per-share amount of FCF. It's calculated like this:
Price to free cash flow = Market capitalization/free cash flow
A lower price to free cash flow indicates a "cheaper" stock. A higher price to free cash flow indicates a more "expensive" stock. However, a lower price to FCF doesn't necessarily mean a stock is cheap. Companies growing very slowly, for example, will tend to have a lower price to FCF ratio than those that are growing very fast.
Say a company has $300 million in operating cash flow, and $150 million in capital expenditures. The free cash flow would be $150 million. If the company's market cap was $3 billion, then it's price to free cash flow would be 20 ($3 billion/$150 million = 20).
When comparing this metric with other equities, take into account the business, the industry it operates in, and how fast it's growing. Companies in different industries are going to have significantly different values. Look at a similar company in the same industry to make a more fair comparison. Also, looking at the trends over a longer period of time can help tell you the direction the company is headed.
Price to free cash flow isn't a perfect valuation. A company can hold off on expenses in a quarter to show a larger amount on hand. And in certain months, the figure won't tell the whole story. Looking at a longer time period, along with other valuations, like sales growth, and cash flow-to-debt ratio is needed to come up with a clearer picture in deciding if the company is worthy of your investment.