Close

    The King of Value: Screening for Low Price-to-Free-Cash-Flow

    by Wayne A. Thorp

    The King Of Value: Screening For Low Price To Free Cash Flow Splash image

    For many investors, cash generation is “king” when it comes to selecting stocks.

    Why cash?

    Sales, dividends, earnings, and asset values may be important factors, but growth in these areas is ultimately fueled by a firm’s ability to generate cash.

    How should “cash generation” be analyzed?

    Ideally, a company should not only cover the costs of producing its goods and services, but also produce excess cash for its shareholders. A growing company must reinvest its cash to maintain its operations as well as to expand. While management can neglect capital expenditures in the short term to preserve cash, there are fundamental long-term growth implications to such neglect.

    “Free cash flow” is considered to be excess cash flow that the company can use as it deems most beneficial. With strong free cash flow, debt can be retired, new products can be developed, stock can be repurchased, and dividend payments can be increased. Excess cash flow also makes a company a more attractive takeover target.

    Free cash flow considers capital expenditures and dividend payments to shareholders. While you can argue that dividend payments are not required, shareholders expect them and they are paid in cash, so they must be considered when calculating free cash flow. Free cash flow is calculated by subtracting capital expenditures and dividend payments from cash flow from operations.

    This article will introduce a screen that seeks stocks selling at low ratios of price relative to free cash flow, and that are generating positive free cash flows on a consistent basis.

    Free Cash Flow Screen

    The screen seeks stocks with:

    • Positive free cash flow over the trailing four quarters and for each of the last five fiscal years;
    • A price-to-free-cash flow per share ratio that is lower than the median value for its industry;
    • A price-to-free-cash-flow per share ratio that is lower than the company’s five-year average.
    Stock Investor Pro, AAII’s fundamental stock screening and research database, includes this free cash flow screen among its preprogrammed screens. The specific criteria used for the free cash flow screen can be found in the AAII Stock Screens area of our Web site.

    Figure 1.
    Price-to-Cash-Flow Screen Performance
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Performance

    AAII tracks over 50 stock screening methodologies and reports the companies passing each of these screens on AAII.com each month. Figure 1 shows the performance of the free cash flow screen (low price-to-free-cash-flow), which is one of the top-performing value strategies tracked by AAII. It has generated a positive return in every year since 1998.

    In addition, the stocks passing the free cash flow screen have been able to outperform the broad market indexes by a wide margin over the last seven years. The only years when the screen failed to outperform these indexes were 1998 and 1999—which were at the tail end of the bull market/tech bubble. During strong bull markets, it is not uncommon for value strategies such as this to lag the overall market. The free cash flow screen has easily outperformed the small-, mid-, and large-cap indexes over this 7¾-year period, gaining a cumulative 482.8% between January 1998 and the end of August 2005, compared to a 25.9% increase for the S&P 500.

    Profile of Companies

    The characteristics of the stocks passing the free cash flow screen are presented in Table 1.

    Table 1. Price-to-Free-Cash-Flow Portfolio Characteristics
    Portfolio Characteristics (Median) Price-
    to-Free-
    Cash-Flow
    All
    Exchange-
    Listed
    Stocks
    Price-earnings ratio (X) 13.7 20.4
    Price-to-book-value ratio (X) 1.8 2.3
    Price-to-free-cash-flow ratio (X) 7 22.3
    EPS 5-yr historical growth rate (%) 6.7 9.9
    EPS 3-5 yr estimated growth rate (%) 10 14.4
    Market cap ($ million) 1,436.10 420.3
    Relative strength vs. S&P (%) 2 11
    Monthly Observations
    Monthly turnover (%) 24  

    Table 2 lists the 30 companies with the lowest price-to-free-cashflow ratios that passed the screen as of September 9, 2005.

    Historically, the number of passing companies is limited to those with the 30 lowest price-to-free-cash-flow ratios, and these companies are posted at the AAII Web site. (This group is also used to calculate the historical performance of the screen.) Since the screen is primarily based on annual and quarterly cash flow data, it is not surprising that it has a relatively low average monthly turnover rate of 24.0%.

    The price-to-free-cash-flow screen is a value-oriented approach, and this is reflected in the median price-earnings multiple for the passing companies, which is significantly lower than the typical exchange-listed stock (13.7 versus 20.4). Six of the companies in Table 2 do not have positive earnings, so they do not have a meaningful price-earnings ratio. Identity management and Web services solutions provider Novell, Inc. (NOVL) has the lowest price-earnings ratio at 4.5, while King Pharmaceuticals (KG), a developer of prescription pharmaceutical products, has the highest price-earnings ratio at 38.6.

    The value orientation is also reflected in the low median price-to-book ratio for the current group of passing companies (1.8), which is lower than the median for all exchange-listed stocks (2.3).

    We limit the companies passing the free cash flow screen to those with the 30 lowest price-to-free-cash-flow ratios, so it is not surprising that the median value for the passing companies (7.0) is considerably lower than that for exchange-listed stocks (22.3). Protection One, Inc. (PONN), a provider of security alarm monitoring services to residential and commercial customers, has the lowest price-to-free-cash-flow value of 0.6. Tommy Hilfiger Corp. (TOM) and Intergraph Corporation (INGR) have the highest ratios at 8.7.

    Value screens such as this tend to isolate larger, more mature companies. Such companies also tend to generate higher levels of free cash flow—prospects for expansion decline as companies age so less cash goes to capital expenditures. The median market capitalization (stock price multiplied by shares outstanding) for the passing companies is $1.4 billion compared to $420 million for exchange-listed firms. Nippon Telegraph & Telephone (NTT), a provider of telecommunications services in Japan, is the behemoth of the group with a market cap of $68 billion. In contrast, Mediware Information Systems (MEDW), a clinical management information systems firm, just clears the screen’s $50 million market cap hurdle at $65.3 million.

    Conclusion

    The analysis of a company’s cash flow is a very revealing study of a firm. The free cash flow measure highlights the effectiveness (or lack thereof) of company operations, including factors such as sales, inventory control, production and employee costs, accounts receivable management, interest payment levels, product development, and capital expenditures.

    Screening for firms with attractive levels of price-to-free-cash-flow is a useful technique to highlight more mature value stocks worthy of further study.

    Screening is only a first step in the stock selection process. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing constraints before committing your investment dollars.  


    Wayne A. Thorp, CFA, is financial analyst at AAII and associate editor of Computerized Investing.


→ Wayne A. Thorp