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Most GAAP financial statements rely on accrual accounting which includes many peculiarities such as depreciation and amortization. The reason is that it helps match income and expenses within the reporting period. For example, even though a piece of equipment might be purchased with cash, if it has a useful life of seven years, cash-based accounting would record a big hit in the quarter the equipment was purchased, while accrual accounting would depreciate it over the expected useful life. This can obscure the true ability of a business to generate cash available for owners. Free cash flow is a non-GAAP metric that can help back out some of these items to help reconcile the differences between accrual and cash-based accounting. Because it is non-GAAP, FCF is not reported on the SEC filings such as the income statement. It can be computed by taking the statement of cash flows and making some adjustments for depreciation and amortization. I have previously written on FCF in the reinsurance industry in this article.

Another way of looking at FCF is that it represents the dollars available to management to deploy where most needed. It can be re-allocated back to investing in the business, to pay down debt, or to investors to fund share repurchases or dividends. More importantly, it indicates that the business itself is generating these dollars, giving the company flexibility in not having to tap the capital markets or sell off parts of its business. However, it is the ratio of price to FCF (P/FCF) that tells you how much the investor must pay for that dollar of FCF. It helps normalize it for comparison across other companies, just in the way that the more familiar price to earnings (P/E) ratio helps for comparing profits.

I thought it might be a useful exercise to compare the free cash flow of five widely-held stocks of mature companies. Since most investors may not be used to comparing price to free cash flow (P/FCF), I also included the more popular price to earnings (P/E) metric, along with another of my favorite ratios, price to book value (P/B).

The companies

I selected a representative group of widely-held stock in a few sectors. The same process could be expanded to included more companies. The goal of the exercise was not to find the single best or worst company to invest in, but to show a representative process that could become a part of your stock selection strategy. Below is a table comparing the selected metrics for these companies, as of February 15, 2013.

PriceP/FCFP/EP/B
Amazon (NASDAQ:AMZN)$265.09305.1-45.24
Apple (NASDAQ:AAPL)$460.169.910.43.39
Berkshire Hathaway (NYSE:BRK.B)$99.7722.618.61.35
Hewlett-Packard (NYSE:HPQ)$16.795.6-1.47
Wal-Mart (NYSE:WMT)$69.3025.514.33.15

Table 1. Comparison of price to free cash flow, price to earnings, and price to book of selected companies. FCF figures are as reported on finviz.com.

Commentary

One observation that I found interesting is that among these five companies, the highest and lowest P/FCF, Amazon and Hewlett-Packard were each recently unprofitable (as indicated by lack of meaningful P/E). Just from looking at these numbers, I can surmise that the market is valuing AMZN as a growth company based on sky-high P/FCF and P/B, while HPQ looks like more of a classic value trap, with bargain basement P/FCF and P/B.

If the primary goal is to invest in a profitable company that sells at an attractive P/E and P/FCF, then Apple seems to fit the bill among this limited universe of 5 arbitrarily-chosen stocks.

One more comment about Amazon: this company just seems to defy all valuation logic. People are willing to pay many times book value (45x) and the P/FCF is so high (305x) that it is more accurate to say they really don't generate much FCF at all (the logic being that they are investing heavily in new technology and warehouses, for example), and you can't even compute a P/E because they haven't generated a profit in several quarters. The rules of logic seem to have been suspended for AMZN, at least for now. I predict one of two things will change: either they will start becoming extremely profitable and might grow into their valuation, or the stock price will drop and bring its valuation down to earth.

In this analysis, price to book is probably not very informative since several of these are technology companies, although it does help show a relative advantage of Berkshire Hathaway. I specifically included Berkshire Hathaway since it is thought of as a free cash flow cash cow, but it's P/FCF and P/E aren't the most favorable. However, its price to book is the best value in this list, which is interesting since it is the metric I most often hear Warren Buffett discuss. Additionally, the company has a buy-back program in place should the price drop below a P/B 1.10. But Berkshire's P/FCF isn't the terrific value that I thought I might find.

Wal-Mart looks fairly average in this analysis. For a mature bricks and mortar retailer, it looks a little richly value on a P/FCF basis and market-average on a P/E basis. I am not sure it has enough of a valuation advantage to outperform the indices. It's worth pointing out that this mature retailer has the second highest P/FCF of this arbitrarily-chosen list of 5 companies. They may be kicking out profits, but they largely aren't dollars available to investors. It would take some digging through the quarterly filings and financial statements to find out why - which I seriously recommend before committing a single dollar to any individual stock, by the way.

Conclusions

This analysis doesn't contain enough data to support using P/FCF as a primary stock selection tool, but it might play a role in narrowing down a list of choices that you identify through other means. I would never invest in a stock after only comparing it to four other stocks, but if you held a gun to my head I'd have to say that AAPL looks like the best investment among these five companies, unless it is heading off some kind of technology cliff and becoming a value trap in the way that HPQ already seems to have done. If only we could forecast the future, this would all be much easier!

Source: Using Free Cash Flow To Compare Company Valuations