I’ve been asked many times, if a particular stock is cheap enough since the PE ratio is very low?
An alluring price-earnings ratio (PER) can easily pull us as investors in, as can financial media that heavily focuses on net profit and its derivative. However, relying upon these measures can lead us down the wrong path and lead to bad investing decisions.
There are some companies with very creative accountants who decide how profits are reported. It is much easier to manipulate income statements than balance sheets or cash flow statements.
Another challenge we will find is how company’s smooth out big purchases like equipment and machinery as non-cash depreciation over many years.
Net profit for companies that rely upon reinvestment for the maintenance and growth of their operations is often an exaggerated version of financial reality.
We like to use another metric that is simpler and more reliable. It is the ‘price to free cash flow ratio’.
Understanding free cash flow
Let’s now try and explain this in more human language without too much use of financial jargon.
‘Free cash flow’ is how much cash that is produced by a company to be utilized for paying dividends, reducing debt and buying back stock, after it has paid its debts, taxes and capital expenses. A business’ intrinsic value is the amount of cash that can be derived from a company for the duration of its existence. It is what matters most to shareholders.
Calculating free cash flow (FCF) is relatively simple. Look at a business’s cash flow statement in its annual report. Take the amount of ‘net cash’ provided by operating activities and subtract the amount labelled ‘capital expenditure’ or ‘payments for property, plant and equipment’ (in other words, what the business spent purchasing new assets to maintain its operations).
There are instances where we may have to adjust this calculation because of the nature of the company.
For example, we can check out one of our favourite companies, Johnson and Johnson (JNJ). It’s a mature company which continues to create incredible shareholder wealth by increasing profits, free cash flow and incredible returns on re-invested capital.
We love to invest in companies which have positive free cash flow like Johnson and Johnson. This means that the company has more cash income than it spends on its growth and operations.
Just be aware that free cash flow can be volatile. This is due to factors such as the timing of payments, cash receipts and bulky capital expenses affecting the calculation. The best way to get an accurate picture is to compare the relationship between free cash flow and net profit over a period of years, which is why Johnson and Johnson (JNJ) is a great example.
We have found that no measurement tool which is foolproof, but the price to free cash flow ratio is a more reliable metric than the price-earnings ratio. When it is expressed as a yield (free cash flow divided by the company’s market capitalisation), it is even better.
We can see what proportion of cash is being withheld for reinvestment by comparing the free cash flow yield to the dividend yield. If the free cash flow yield generally falls below the earnings yield, we should question the quality of the earnings.
Free cash flow yields will allow us to compare different asset classes at the same time. The ultimate goal, regardless of whether we are investing in property, stocks or bonds, is how much we will need to invest and how much cash we will generate from our investment.
If all factors are equal, it may be worth paying more per dollar of net profit if a larger part of the return flows through as cash. Depending upon their free cash flow yield, stocks with a high price-earnings ratio (PER) may still be a better investment than those with a low PE ratio.
In summary, high quality growth businesses which can re-invest at high rates of returns like a Johnson and Johnson, means a lower fee cash flow yield of less than 5% can be acceptable. Whereas we definitely should demand a much higher yield for a poorer quality business.
However, we may then want to then ask ourselves why we are holding poor quality businesses in our portfolio when so many other great quality ones are available?