What is the Price-to-Free Cash Flow Ratio (P/FCF)?
The price-to-free cash flow ratio (P/FCF) is a valuation method used to compare a company’s current share price to its per-share free cash flow.
How Does the Price-to-Free Cash Flow Ratio (P/FCF) Work?
The formula for the price-to-free cash flow ratio is:
Price to Free Cash Flow = Market Capitalization / Free Cash Flow
For example, let's assume that Company XYZ has 10,000,000 shares outstanding, which are trading at $3 per share. The company also recorded $15,000,000 of free cash flow last year. Using the formula above, we can calculate Company XYZ's price-to-free cash flow ratio as follows:
Price to Free Cash Flow = (10,000,000 x $3) / $15,000,000 = 2.0
The data needed to calculate a company's free cash flow is usually found on its cash flow statement.
Why Does the Price-to-Free Cash Flow Ratio (P/FCF) Matter?
Investors often hunt for companies that have high or improving free cash flow but low share prices. Low P/FCF ratios typically mean the shares are undervalued and prices will soon increase. Thus, the lower the ratio, the 'cheaper' the stock is.
The price-to-free cash flow ratio is not the same as the price-to-cash flow ratio. The difference between the two is that the former subtracts capital expenditures from cash flow, thereby leaving cash flow that is available to drive non-asset-related growth.
It is important to note that free cash flow relies heavily on the state of a company's cash from operations (CFO), which in turn is heavily influenced by the company's net income (excluding depreciation). Investors should also be aware that companies can manipulate their free cash flow by lengthening the time they take to pay the bills (thus preserving their cash), shortening the time it takes to collect what's owed to them (thus accelerating the receipt of cash), and putting off buying inventory (again thus preserving cash). It is also important to note that companies have some leeway about what items are or are not considered capital expenditures, and the investor should be aware of this when comparing the free cash flow of different companies.