Free cash flow: Formula for investment success

Buying shares with the help of cash flow as a selection criterion has delivered convincing results in the past. This trend is likely to continue in an environment of low growth – and low interest-rates.

When looking for interesting stocks, a small but subtle difference can usually be detected in the procedure adopted by private and professional investors. While private investors often concentrate on the price-earnings ratio or how much a stock compared to earnings per share costs, many institutional investors focus on a different key ratio: They swear by the (free) cash flow as a selection criterion and by its relationship to the enterprise value.

Free-cash-flow-1-(Read-Only)That may sound somewhat abstract, but it is relatively easy to understand. Ultimately, it is the amount of money moving into and out of a business. The cash flow statement generally represents earnings before interest, taxes, depreciation and amortization. Finally, cash flow gives information about the internal financing power of a company. If the cash flow is high, that means the company is less dependent on capital from external sources.

The generated cash flow margin indicates, in percentage points, how much cash flow there was, compared to sales.

Free cash flow (FCF) is often even more popular with financial professionals as a financial indicator. This term refers to the cash flow from operations minus the capital expenditures. FCF is used as a key metric because it is considered a comparable accurate measure of how much cash a business actually has to service debt, pay dividends, buy back shares or invest in its operations. Another figure used for valuing companies is the free cash flow yield. It is calculated by dividing the free cash flow per share by the current market price per share. A higher number is typically a sign of undervaluation, based on the company’s ability to generate cash.

Two main advantages

Cash flow is popular primarily for two reasons: First, as an indicator it can be manipulated less than the earnings per share. This is an important factor, especially in the current environment. Many chief financial officers tend to artificially prop up their earnings, for example, by declaring negative earning components as special cases. Commenting on this trend, Bank of America Merrill Lynch strategist Savita Subramanian says, “Investors have been concerned about the quality of earnings, and while companies can manipulate earnings, they can’t manipulate cash.”

Second, cash flow is considered a valuable tool for identifying promising stocks. Backtested calculations about the historical performance of stocks underpin this impression. According to studies, shares of companies with a strong cash flow deliver a compelling performance. Applicable research was provided by such prominent resources as Ned Davis Research, Barclays and Bank of America Merrill Lynch. According to the latter, among the value-based stock selection criteria, a high free cash flow in relation to the enterprise value has delivered the best performance over the long run. Calculations for the period from Dec. 31, 1988 through Dec. 31, 2015 show an average annual performance of 18 percent for the S&P 500 Index members with the highest free cash flow compared to the enterprise value. In comparison, the second best shares with the highest estimated earnings per share yield delivered only 15 percent p.a., and the selection criteria of a high book value compared to the share price delivered an average annual performance of 12 percent. These results bring strategist Subramanian to a clear conclusion: “Investors are willing to pay for free cash flow. Therefore, when it comes to the valuation of companies, free cash flow is king.”

Free-cash-flow-2-(Read-Only)The results of a backtest conducted by Ned Davis Research are also impressive. “Investing in the companies with the highest free cash flow to enterprise value ratio has been the best strategy among the 188 quant strategies we track,” says Europe-Strategist Vincent Deluard.

Since March 31, 1999, with an average annual plus of 18.61 percent, it would have been particularly rewarding to go long with companies with a high free cash flow compared to the enterprise value, and at the same time to short the bottom decile of companies based on the same criteria.

On top of that, analysts at investment bank Barclays recommend paying attention to whether a company relies heavily on external financing for earning its money. This has to do with the fact that over the past 15 years companies with a high ratio of cash flow from financing activities to market capitalization delivered significantly lower returns compared to companies with a low ratio of cash flow from financing activities.

Interest rate environment gives support

Despite all the advantages, cash flow as a means of identifying lucrative shares is no guarantee of making money. Such a thing simply does not exist on the stock market, and anyone who promises something different either does not know or is a charlatan. General disadvantages include fluctuations in the investment cycle or date-related distortions, though these can be mitigated by longer observation periods than just one year. Moreover, the conventional calculation is based on historical data, and if one tries to estimate future cash flows and their current value, the question of the appropriate discount rate is usually a problem.

Among the available tools, however, cash flow nevertheless stands out, and in the future investors may expect quite good investment results based on that selection criterion. This expectation also has to do with the current, difficult environment. According to analyst Credit Suisse HOLT, in such a situation, high free cash flow helps a company to operate profitably and to cover dividends and interest payments. Furthermore, J.P. Morgan believes that “in the current environment of sub-trend growth, low inflation and low bond yields, stocks that deliver healthy FCF yields will continue to perform well.”

With regard to the Wall Street, the problem in an already long-lasting bull market is that the current valuation, on average, is higher based on a cash flow basis than in most other regions of the world. But a broad-based stock market like the one in the U.S. is big enough that stock-pickers can always find a few interesting candidates to buy.

Looking at the cash flow valuations or the cash flow growth rates, bioanalytical and electronic measurement solutions-provider Agilent Technologies makes a good impression, as does health insurer Aetna, wafer fabrication equipment supplier LAM Research, IT software-specialist CA Inc., and Hewlett Packard. Despite the fact that the charts of these companies look promising, as always, there is no guarantee that their share prices will finally perform well. To protect against negative surprises, the use of stop-loss-techniques is advised.