Significance of Price to Free Cash Flow ratio

 

Significance of Price to Free Cash Flow ratio

 

Like P/E ratio, EPS, PEG ratio, Price to free cash flow is also an important valuation method for stock analysis.

Free cash flow is the indicator of the growth of the business or a company. However normal investor does not go in-depth during stock valuation but the professional investor is using this for correct valuation analysis.

For the business owner, managers, and key persons Free Cash flow value helps the company to decide business expansion or restrict the activities.

What is free cash flow?

Free cash flow is the amount of money remained after paid up of all expenditures like debt, employee, plant maintenance, and rent, etc.

This free cash flow company may use for investing purposes like expansion, acquisitions, investment in fixed deposit, Mutual fund, etc. Under the head of CFI

Or else it can be used in financial activities like repayment of the debt, dividend pay-out or buyback of shares, hiring employees under the head of CFF.

Where you will get it?

It can be seen in the cash flow statement of the company but sometimes you may be required to refer the annual report for the correct picture.

When free cash flow analysis to be used?

In the company’s financial statement if you find the marginal or large difference between Net profit and operating cash flow (CFO) then this value (FCF-Free cash flow) to calculated or to be identified.

How & When there can be a large difference in Net profit & Operating Cash Flow?

If we see the typical P & L statement of a company we will find that Earning or Net profit can be manipulated. In P & L statement, non-cash items like depreciation, amortization is included. The depreciation of the asset is decided by the company. Actually, the depreciation amount does not go outside the company, so if company shows high deprecate amount then it will impact the net profit value or earning. There will be a large difference in earning and operating cash flow.

And also if we compared with book value then book value also can be manipulated. Because it also includes the depreciation amount. If you identify the asset value whatever mentioned in accounts or book value, in the market it may not sell the assets at that price quoted in P & L statement. Hence book value is also not a good indicator but if you calculate the price to cash then it will give a clear picture, as cash cannot be manipulated, so it needs to be analyzed

How to calculate Price to cash flow? And How to interpret it?

The formula for free cash flow

Price to cash flow = Share price/Operating cash flow per share

Here Share price is the current share price.

Operation cash flow can be seen in the cash flow statement.

The Price to Cash flow is identical to the P/E ratio. As in this formula we use to take net profit divided by earning per share.

EPS and operating cash flow are closely related to each other. When there is a large difference in EPS and operating cash flow then the Price to cash flow is to be calculated.

Sometimes for calculating the price to cash flow some analyst uses free cash flow (FCF) instead of operating cash flow per share. And this is ideally correct formula as in free cash flow we use to deduct capital expenditure from operating cash flow

Price to Cashflow = Share price/ Free cash flow per share.                                      Or Price to Cashflow = Market Capitalization/Free cash flow.

 

Free cash flow = Operating cash flow (CFO) – capital expenditure

 

Let us understand from the company’s P & statement and typical cash flow statement.

Typical P & L statement		Typical Cash flow statement
Revenue		PBT
Cost of Goods Sold (CGOS)(-)	Cannot be manipulated	Depreciation(+)
Gross Profit		Taxes(-)
Market & Sales (-)	Cannot be manipulated	Change in Working Capital W.C (-)
Office & Admin(-)		Operating Cash flow
EBITDA		Capital Expenditure(-)
Depreciation (-)	Can be manipulated	Free cash Flow
Amortization(-)	Can be manipulated	Investment(+)
EBIT		Financing C.F.(+)
Interest(-)	Cannot be manipulated	Net Cash flow
PBT
Tax(-)	Cannot be manipulated
Net Profit

If we see the typical Company’s P & L statement Depreciation and Amortization can be manipulated as these are noncash items. Because depreciation of an asset is decided by the company

But In typical cash flow statement free cash flow is calculated after deduction of capital expenditure like expenses on plant and maintenance.

For example, the Operating cash flow of company ABC is 500 crore & its Net profit 400 Cr

·        In this case, operating cash flow may be high because company may have considered high depreciation costs which are added in the cash flow statement.

·        Also, the company may have used in expansion,

·        The company may have used in plant maintenance like 300 crores

But is not clear from net profit ( P & L statement) Hence if you calculate Price to cash flow then it will get clear from free cash flow (FCF)

Whenever P/Free cash flow is low then it is better because it shows that it gives high returns. Historically it is proved.

Let us see the live example as on

Asian Paints financials as on March 2018:

1.     Market capitalization : 1,20,494.00

2.     P/E: 55.53

Now we will calculate the price to cash flow is there any difference in P/E value and Price/ FCF value?

Cash flow statement:

1.     Cash from operating activities: 2136 Crores

2.     Investing Activities:                        :1370 Crores

 

Price/Operating cash flow = Market Capitalization

                                                = 120494/2136

                                                = 56.4

It is closely with the P/E ratio, no much difference. Hence from these value, there is no manipulation 

P/FCF

In the free cash flow we are getting the clear capital expenditure so we have to see annual report

From Cash flow statement:

1.     Purchase on plant and equipment : 1354 crores

2.     FCF = Cash flow from operation activities- Investing activities

       = 2136-1354 

       = 778 crores.

P/FCF = 120494/778

           = 155

Here the Price/FCF is very high this is because the companies going for high expansion activities.

Now let us understand why capital expenditure is high?

Is the company doing expenses on capital expenditure every year?

If the company is going for expansion then it is better but it is going for renewal then it is a bad thing it gives the wrong signal and in such stock, the investor should not invest.

Conclusion: In company’s financial statement if you find the marginal or large difference between Net profit and operating cash flow (CFO) then this value (FCF-Free cash flow) to calculated or to be identified.