Seize a Competitive Advantage – Or Don't Compete!

Price To Free Cash Flow Definition – Explanation – Example

What is Price to Free Cash Flow?

Price to free cash flowPrice to free cash flow is an equity valuation tool that compares a company’s market price per share to its free cash flow per share (FCF). This metric is very similar to the price to cash flow valuation metric, but it is considered a more precise measure.  This is because it uses free cash flow, which subtracts capital expenditures (CAPEX) from a company’s total operating cash flow.  As a result, it reflects the actual cash flow available to fund non-asset-related growth. Companies utilize this statistic either to develop their businesses or to maintain acceptable levels of free cash flow.

What is Free Cash Flow?

Free cash flow (FCF) is the cash that remains after a company pays for its operations and makes any capital expenditures.  Capital expenditures are purchases of physical assets such as property and equipment. Net income is linked to, but not the same as, free cash flow. Net income is typically used to assess a company’s profitability.  However, free cash flow gives a deeper understanding of a company’s business strategy and financial health. Value investors use this ratio to assess a company’s financial position in relation to its current stock price. It is a more stringent metric than the price to cash flow ratio since it deducts capital expenditures from cash flow.

How to Find the Price to Free Cash Flow Ratio

The free cash flow of a firm is a valuable metric to understand.  It is a fundamental indication of a company’s potential to create extra revenues.  In turn, these revenues are an important factor in driving stock prices. The ratio is calculated as follows:

Price to Free Cash Flow = Market Capitalization / Total Free Cash Flow

Example

For example, let’s assume that Company ABC has 1,000,000 shares outstanding, which are trading at $10 per share. The company also recorded $1,600,000 of free cash flow last year. Using the formula above, Company ABC’s price-to-free cash flow ratio can be calculated:  Price to Free Cash Flow = (1,000,000 x $10) / $1,600,000 = 6.25

The data needed to calculate a company’s free cash flow is usually found on its cash flow statement.

Why Does Price to Free Cash Flow Matter?

Investors often seek firms with strong or increasing free cash flow but low share prices. Low P/FCF ratios often indicate that the stock is cheap and that prices will shortly rise. As a result, the smaller the ratio, the ‘cheaper’ the stock is considered to be. The price-to-free cash flow ratio and the price-to-cash-flow ratio are not the same things. The free cash flow metric subtracts capital expenditures from cash flow.  This leaves only the cash available to support non-asset-related growth.

Free cash flow is driven by the status of a company’s cash from operations.  In turn, this figure is heavily influenced by net income. Companies may control their free cash flow by delaying the payment of invoices.  Also, by increasing the time it takes to collect outstanding receivables, and deferring the purchase of inventory. It also relies on what is defined as capital expenditures.  This convention might change across different firms and industries.

How Investors Use the Price to Free Cash Flow Metric

The price to free cash flow ratio is a value metric.  Lower numbers generally indicate that a company is undervalued.  In other words, its stock is relatively inexpensive in relation to its free cash flow. Higher ratios, on the other hand, may suggest that the company’s stock is overpriced in proportion to its free cash flow. Therefore, value investors choose firms with low or declining prices to free cash flow values.  This suggests high or growing free cash flow totals and comparatively cheap stock share prices. Value investors often avoid firms with high ratios.  This signals that the company’s share price is relatively expensive in comparison to its free cash flow. In other words, the lower the price to free cash flow ratio, the more a company’s stock is seen as a better deal or value.

Comparing a company’s price to free cash ratio to that of similar firms in the same sector is most beneficial. This provides for an apples-to-apples comparison.  The metric may also be used to determine if the company’s cash flow to share price value is increasing or decreasing over time. Always consider that companies can manipulate the statement of their free cash flow on financial statements.  They do this by deferring inventory purchases until after the period covered by the financial statement.  As a result, this can have an impact on the reported free cash flow as reported.

What is a Good Price to Free Cash Flow Ratio?

Lower P/FCF ratios often imply that a firm is undervalued.  As a result, its stock is relatively inexpensive in proportion to its free cash flow. Higher P/FCF ratios, on the other hand, suggest that the company’s stock is comparatively expensive. Therefore, value investors choose firms with low or declining ratios.  Conversely, high or growing free cash flow totals, and relatively cheap stock share prices. It is better to compare price to free cash flow ratios across similar firms in the same industry. Also, the P/FCF statistic can be studied over a longer time period.  This helps identify if the company’s cash flow to share price value is increasing or dropping.

What is a Cash Flow Statement?

A cash flow statement’s objective is to offer a complete picture of what occurred to a company’s cash.  Activity is measured over a set time known as the accounting period. It displays a company’s capacity to function in the short and long term.  Ultimately, it depends on how much cash flows in and out of the firm. The cash flow statement is typically broken into three sections:

  • Operating activities – detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses.
  • Investing activities – include cash flow from purchasing or selling assets—think physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt.
  • Financing activities – detail cash flow from both debt and equity financing.

You may use the cash flow statement to understand how much cash various sorts of operations create.  Then, you can make company choices based on your financial statement research. A company’s cash from operational income should ideally frequently surpass its net income.  A positive cash flow reflects on a company’s capacity to stay viable and expand its activities. It’s important to note that cash flow is different from profit. This is why a cash flow statement is often interpreted together with other financial documents.  For example, a balance sheet and income statement.

Up Next: What Is Rule 147?

Rule 147SEC Rule 147 allows small local companies to raise intrastate funds without having to register with the Securities & Exchange Commission. Rule 147 can be used by a company to raise funds within its own state of operations.  Further, they can do this without actually registering with the Securities and Exchange Commission (SEC). This ruling is also known as the “safe harbor” rule.  It usually only applies to small companies that want to raise money locally without incurring the expensive fees associated with registering with the SEC.

The Intrastate Exemption is applicable to both public and private corporations based in the United States. If the conditions of the exemption are satisfied, both SEC reporting and non-reporting issuers may rely on the Intrastate Exemption. The intrastate offering exemption does not impose any restrictions on the size or number of investors. However, each offeree and purchaser’s residency should be determined by the issuer. The exemption may be withdrawn if any of the securities are offered or sold to even one out-of-state individual. Without the exemption, the issuer may be in violation of state and federal securities laws.

Leave a comment

Your email address will not be published.