PM IMAGES/GETTY IMAGES
The price-to-free money flow ratio shows whether an organization is capable of reward impatient shareholders.
Written by Hyunsoo Rim and Segun Olakoyenikan; Edited by William Baldwin
YYou knew Tesla was expensive: It trades at 63 times its latest quarterly earnings. Did you recognize that its money flow multiple is a fair larger outlier at 10 times P/E?
The ratio is price divided by free money flow. It compares the market value of common stock to the free money flow generated by an organization. A low ratio is an indication that an organization is affordable.
The P/FCF ratio is comparable to the price-to-earnings ratio. However, free money flow will be very different from earnings. An organization could have high earnings but have little ability to build up money. The money earned goes back into the corporate, either to exchange outdated equipment or to expand. Such firms could also be reasonably valued on the P/E ratio, but appear quite expensive on the P/FCF ratio.
Tesla’s profit of $12 billion within the 12 months ended June 30 wasn’t bad, but when the corporate wound down its investments, it had significantly less left within the coffers. Tesla is putting much of its profit into recent factories, artificial intelligence and a fleet of leased cars. It doesn’t pay a dividend. This stock is a pure growth story. Two birds with one stone.
Celanese Corporation is sort of a contrast: it is affordable relative to each its earnings and the money it generates. Its profit is the sort you’ll be able to put within the bank: it’s utilized in shareholder-friendly ways to pay dividends, buy back stock, or pay down debt. Its growth will not be exciting. Instead, shareholders are left with a bird of their hand.
What is free money flow? In the only evaluation, you add depreciation expenses to net income after which subtract capital expenditures. If the depreciation expenses used to calculate net income are greater than the quantity spent on property improvements, then free money flow will likely be greater than net income. This is the kind of company that’s able to paying a pleasant dividend.
A more precise definition begins with the “cash flow from operations” number on the balance sheet. To determine money flow from operations, accountants add to net income the noncash costs of depreciating property, amortizing goodwill, and carrying costs of worker options. They then think about changes in working capital that either absorb or release money. An increase in accounts receivable (brought on by customers taking their time to deposit a check) reduces money flow from operations; a rise in accounts payable increases money.
Now subtract capital expenditures. That will likely be a combination of what is needed to maintain existing customers from leaving and what can generate growth. In the primary category falls: replacing outdated tools or yesterday’s blockbusters or dwindling oil wells. In the second category falls: a few of Tesla’s recent “gigafactories.” Last quarter, Tesla earned $3.8 billion from operations but spent $5 billion on real estate, plant and equipment. The company borrowed money to maintain going.
The money flow statement within the annual report generally doesn’t distinguish between maintenance and expansion. Usually only the overall capital expenditures are reported. Investors haven’t any selection but to subtract capital expenditures and use the resulting free money flow figure together with many other clues (corresponding to sales) to guage whether or not they are investing in a growing company or one which is running fast to remain afloat.
Like the P/E ratio, the P/FCF has its limitations. The ratio shoots up or becomes meaningless when its denominator is small or negative. Different data sources use different definitions of the variable. The ratio will be quite volatile: Morningstar calculates that the price-to-cash flow ratio for Netflix was 417 in 2021 and 36 in 2023.
The table highlights low cost firms which have a low money flow multiple coupled with a low earnings multiple within the YCharts database. They are followed by expensive firms with a P/FCF that’s each high and significantly higher than the P/E.
MORE FROM FORBES
