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Price to FCF: valuation against free cash flow

Definition of the price to FCF ratio, its formula, where to find FCF in an annual report, how to compare it with its historical average, usual thresholds, traps and sectors.

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Definition

The price to FCF ratio divides market capitalization by annual free cash flow (FCF). It resembles the P/E, but rests on the cash the business actually generates after investment, which is harder to dress up than accounting profit. Comparing it with its own historical average places today’s valuation against the company’s past.

Formula

Price / FCF = market capitalization / (operating cash flow − capital spending). Gap to the average = (average price / FCF − current price / FCF) / average price / FCF

Where to find it in an annual report

FCF is calculated from the cash flow statement: operating cash flow minus purchases of property, plant, equipment and intangible assets. Market capitalization is the share price multiplied by the number of shares outstanding. The 5-year average is calculated with past annual reports and the share prices of the time, or read on data sites such as Stock Unlock.

Common thresholds

Long-term quality: the preset strategy does not judge the absolute level but the gap to the 5-year average. Green at or below the average, orange up to 20% above it, red beyond. In absolute terms, a price to FCF of 15 corresponds to an FCF yield of about 6.7%. Quality companies often trade at 25 to 35 times their FCF.

In the preset strategies

Preset strategy Criterion met To monitor Criterion not met
Long-term quality (calculated) Price / FCF against its 5-year average ≥ 0% -20% to 0% < -20%

Pitfalls

  • FCF for a single year varies a lot: a large investment or a delay in collections makes it drop, and the ratio soars.
  • A historical average taken over a period of market euphoria makes the current price look misleadingly reasonable.
  • Stock-based pay increases FCF without any cash going out: some analysts subtract it from FCF.
  • A company whose profile has changed (major acquisition, new line of business) is no longer comparable with its own average.

Where it does not apply

  • Banks and insurers: FCF makes no sense there.
  • Companies with negative or very irregular FCF, in a heavy investment phase: the ratio cannot be read.

A worked example

A fictitious company, called Company Y here, has had an average price to FCF of 25 over five years. Today it is 22. The gap is (25 − 22) / 25 = 12%: the valuation is below its average, so the criterion is green. If the current price to FCF were 28, the gap would be −12%: orange, because it is less than 20% above the average.

Price to FCF and FCF yield

The two ratios say the same thing the other way round. The FCF yield divides FCF by market capitalization: a price to FCF of 20 corresponds to a yield of 5%.

Sources