Free Cash Flow: An Investors Best Friend

By Daniel Sparks - September 22, 2012 | Tickers: AAPL, GOOG, IBM, ISRG, MSFT | 0 Comments

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Managers create value by generating free cash flow. Free cash flow is the good stuff! It is the cash left over for fun things like investment, dividends, share-repurchase programs, and long-term debt repayment after short-term commitments have been met. Therefore, free cash flow can be used to grow the business, increase equity, or reward shareholders with cash dividends.

I love using free cash flow as a starting point in my investment research. In fact, it's usually the first thing I look at. I skip the income statement and go right to the cash flow statement. I find capital expenditures and subtract it from the line that says something like, "cash provided by operations." I go at least 5 years back and then I step back and look at the trend of free cash flow. If there is a consistent trend of solid free cash flow generation, I've probably found a business worth looking at a bit closer. Even better, sometimes the trend is an upward trend!

Two awesome free cash flow ratios
Two ratios using free cash flow can paint a revealing story:

FCF-to-sales = FCF/sales

FCF yield = FCF/market value

Let's take a look at several companies and see how they measure up using these two ratios. Here are 5 companies with very good FCF/sales ratios.

While each of these companies has very good FCF-to-sales ratios, their individual ratios vary widely from each other. This is because some industries, in general, are more profitable than others. Microsoft for example, generates most of its revenue from software related products which have ridiculously high profit margins. Apple, on the other hand, generates most of its revenue from consumer electronics, which have historically low profit margins. Therefore the fact that Apple can turn 28% of every dollar of revenue into free cash flow is very impressive. Intuitive Surgical benefits from its patented Da Vinci and lack of competition. IBM offers IT service and solutions and its competitive advantage is mostly due to the scale of its solutions that keep customers coming back.

But as an investor we need to throw in another dynamic to this analysis: Price. We can do this by looking at free cash flow yields.

AAPL Free Cash Flow Yield data by YCharts

So even though all of these companies are generating plenty of cash for each dollar of revenue relative to their industry, some are more favorably by the market than others. Several things catch my eye right away:

Microsoft, relative to its ridiculously high FCF-sales ratio of 40% trades at a very enticing FCF yield of 11%. Apple, despite a very high FCF-sales ratio (compared to competitors) and enormous FCF growth over the last decade, trades at a relatively high FCF yield of 7%. And on the other end of the spectrum, Intuitive Surgical trades at a premium to its FCF with a yield of only 3.29%. Finally, we have two companies that seem fairly priced, all things considered: Google and IBM. Their FCF yields are 5% and 7%, respectively, which seem reasonable.

The bottom line
FCF-to-sales and FCF yield are both great ratios to keep an eye on. It's ultimately free cash flow that creates value in the long haul.

What are your favorite investment ratios? Let me know in the comments below.

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