Free Cash Flow: Another Metric To Use For Stock Evaluation

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Two of the factors that Wall Street analysts and investors tend to focus on when deciding whether a stock is a good investment, sometimes at the exclusion of others, are earnings and earnings growth.

Past earnings can be compared to the stock price using the price to earnings ratio (P/E). Future earnings growth is incorporated into an evaluation using the PEG ratio (P/E divided by EPS growth). Trends in either calculation can provide clues as to the future direction of the stock price. 

Another factor that can be part of the investment decision is free cash flow (FCF). It can be calculated by one of the following equations:

1. [Earnings Before Income Taxes * (1-Tax Rate) + Depreciation & Amortization] - Change in Net Working Capital - Capital Expenditure

2. Cash Flow - Capital Expenditure

Positive free cash flow is characteristic of a solid company. There will be funds available to pay off debt, buy back shares and/or pay a dividend. Negative free cash flow is not necessarily a bad thing as long as money is used to fund long-term expansion or growth. The situation should be analyzed over a fairly long time horizon, say 3 to 5 years, to get a better handle on where the money is going.

Apple (NASDAQ: AAPL) generates lots of free cash flow. The sharp upward trend started after the company introduced the iPhone. Prior to that Apple had a relatively constant FCF for a number of years (even after the release of the iPod in 2001). The amount has now increased to about $42 billion. Apple started to use some of that cash to pay a dividend earlier this year. 

Two trends could affect future free cash flow. Apple is projected to have a slowdown in earnings growth from about 60% per year to around 25%. And there are reports that the company plans to increase capital spending over the next few years in order to improve iPhone and iPad production.

<img src="http://media.ycharts.com/charts/e6544ff0d5938fee21e174ce49d2337a.png" />

AAPL Free Cash Flow TTM data by YCharts

In contrast, the reorganized General Motors Company (NYSE: GM) has had declining free cash flow and earnings growth has lagged since its IPO in 2009. 

One reason for the poor performance might be the heavy capital investments GM has had to make. The company is reported to have spent over $1.2 billion in development of the Chevy Volt and does not have much to show for its efforts yet. Only 21,500 units have been sold to date. At a base sales price of $40,000 the loss has been about $15,000 per vehicle. Even cash infusions and investments by the federal government have not helped. 

Earnings growth, and possibly, free cash flow, are expected to pick up a bit in the future. 

Another company that generates lots of cash is The Procter and Gamble Company (NYSE: PG). The maker of Tide, Pampers, and Gillette products reported over $3.2 billion of free cash flow this year. Over the past 5 years FCF has increased by 20% although the rate is slowing a bit which is mirroring a general earnings growth decline. EPS decreased from $3.93 to $3.18 over the past year.

The company has made good use of its cash in the past by paying a dividend (since 1890) and increasing it for 56 straight years and buying back shares, returning lots of value to investors. Unless the bottom falls out it should continue to do that. 

The oil and gas giant ExxonMobil (NYSE: XOM) is another cash generator. Although it competes in a capital-intensive industry, last year the company had over $15 billion in free cash flow. The number is expected to rise to about $20 billion this year. The earnings and free cash flow growth should continue at about the same rate for the foreseeable future based upon current projections.

<img src="http://media.ycharts.com/charts/1fdd31ff31dcc441e6db50ef3a8b8a95.png" />

GM EPS Diluted TTM data by YCharts

 In addition to looking at earnings and earnings growth another statistic to keep an eye on is free cash flow. It can provide some indications as to the future direction of the company.

 

 

 


Mathman6577 owns shares of Apple and The Procter & Gamble Company. The Motley Fool owns shares of Apple and ExxonMobil. Motley Fool newsletter services recommend Apple, General Motors Company, and The Procter & Gamble Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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