The Case for Free Cash Flow in Stock Selection

S&P Dow Jones Indices quietly launched a new index last year focused on free cash flow. It outperformed the S&P 500 index with a 21.9% return over the 12-month period ended in May 2025, versus the S&P 500’s 13.5% return. The S&P 500 Quality FCF Aristocrats index’s 15-year annualized return of 17.0% is the highest of all S&P 500 subindexes. (S&P Dow Jones Indices used April 20, 2001, as the index’s first value date.)

The S&P 500 Quality FCF Aristocrats seeks out S&P 500 companies that have all of the following traits:

• Positive free cash flow for at least 10 consecutive years,
• High free cash flow margin and
• High free cash flow return on invested capital (ROIC).

The Pacer S&P 500 Quality FCF Aristocrats ETF (LCOW) tracks this index. This exchange-traded fund (ETF) was launched less than two months ago. However, you don’t need to own the ETF to incorporate one or more of the S&P 500 Quality FCF Aristocrats’ traits in your own strategy. A simple calculator and the financial statements available on AAII.com will provide you with all of the necessary data. (To view these financial statements, simply type a company’s name or ticker symbol into the search box at the top left on AAII.com to access its Stock Evaluator page. Then click on the Financials tab.)

What Makes a Free Cash Flow Aristocrat

Free cash flow is calculated using the common formula of cash from operations minus capital expenditures (capex). The free cash flow margin is free cash flow divided by revenues. Free cash flow return on invested capital is calculated as:

Free Cash Flow ÷ (Total Debt + Total Equity)

As I explained in last week’s AAII Dividend Investing (DI) commentary, free cash flow is the cash that does not need to be reinvested back into a company. (We at AAII also subtract dividends from cash from operations when calculating the free cash flow payout ratio. This is done to see how much free cash is left over after dividends have been paid.)

Cash from operations is the net cash realized from normal business operations. It is earnings adjusted for outflows (e.g., increases in inventories), inflows (e.g., decreases in accounts receivable) and the adding back of noncash expenses like depreciation.

Capex is dollars spent on property, plant and equipment. These are amounts a company needs to spend on itself to keep its facilities running or to enable expansion. Even a service-oriented company will have capital assets (e.g., office furniture).

Free cash flow aristocrats are companies with the ability to consistently generate free cash flow. This cash can be used to further grow the business, pay dividends and/or repurchase stock. The requirement for 10 or more consecutive years of positive free cash flow also identifies companies that are fundamentally strong. (You can lower this requirement to five or seven years and still find consistent free cash flow generators.)

Comparing the Free Cash Flow Aristocrats to Other Companies

The S&P 500 Quality FCF Aristocrats ignores growth rates, valuation, dividend yields, volatility and price momentum. These aspects make it very different relative to the other S&P 500 subindexes. (There are 16 other indexes that S&P Dow Jones Indices tracks in its monthly S&P Factor Indices Dashboard.)

Free cash flow aristocrats have realized stronger five-year revenue and earnings growth than the comparable S&P 500 universe. [This universe excludes banks, insurance companies and real estate investment trusts (REITs) because of their different financial structures.] Valuations are also higher. The median price-earnings (P/E) ratio is 31.1 for the aristocrats, versus 24.9 for the comparable S&P 500 universe. The free cash flow aristocrats have lower dividend yields, though they repurchase more of their stock, as evidenced by the higher buyback yield in the table.

Companies that spend less on purchasing and maintaining capital assets tend to have higher levels of return on assets (ROA). Return on assets is net income divided by average total assets. Being “asset light” contributes to higher free cash flow margins and higher free cash flow return on invested capital. As a group, free cash flow aristocrats have higher return on assets than the typical large-cap stock.

There is no performance data on the free cash flow aristocrats prior to 2001. We do know that requiring fundamental strength works across strategies. Positive free cash flow is among the traits associated with financially strong companies.