How To Measure The True Operational Performance (Profitability) Of A Business Using The Price/Free-Cash-Flow (P/FCF) Ratio – By Shiraz Lakhi.
In the previous article, I discussed the advantages of using ‘enterprise-value’ as a superior, more exact method of determining the true ‘worth’ of a business, as opposed to the market-cap figure. The enterprise-value is what a potential acquirer would theoretically pay to take over a business. Similarly, the buyer/investor would also want to know more detailed aspects of the company’s ability to general cash-flow and profits.
Many traders and investors are already familiar with the popular price-to-earnings ratio (or P/E ratio), which provides some instantaneous, convenient measure of how the earnings-per-share compare to the stock price of a company. For instance if the share price of a company is $2.00, and the earnings for the year are 20 cents per share, then the P/E ratio is 10 (price/earnings). The P/E can then be compared with other companies in the same sector/industry in an effort to discover ‘undervalued’ or ‘overvalued’ stocks. If company A has a P/E ratio of 8 and company B has a P/E ratio of 12, then company A appears to offer better ‘value’.
There is however, a significant flaw with the P/E ratio. The ratio depends on the ‘price’ and the ‘earnings’ figure, both of which are not the truest reflection of what a company is ‘worth’ (price) or whether it is genuinely ‘profitable’ (earnings), in the strictest ‘operational’ sense. In this article, I will address the ‘earnings’ part of the equation.
Many less sophisticated investors take the earnings-per-share figure as a reflection of the profitability of a company. Relying on the much touted ‘earnings’ data carries considerable risk for investors. Earnings are often subject to dubious accounting tactics, which can disguise the true reflection of operational performance – for instance, tactical accountancy can carry forward (or backwards) irrelevant (non-operational, and non-recurring) entries which results in a flawed earnings figure.
There is of course, a more recent version of earnings, known as EBITDA (Earnings before Interest, Tax, Depreciation & Amortization). This metric has become popular, aimed at replacing the over-simplistic ‘earnings’ data, but again, the EBITDA also contains various noted flaws and does not remove the potential risk of questionable accounting. This is why, the only true, untainted, reflection of a companies ability to generate cash (profits), is via the “free cash flow” metric. Traders can view the ‘Free Cash Flow’ data for any business, via data providers such as Bloomberg, Thomson, and Yahoo Finance (simply enter any symbol, and hit ‘key statistics’).
In my own trading, I utilize the ‘enterprise-value’ metric, as part of my analysis to work out the free-cash-flow-yield. The free-cash-flow-yield is simply the free-cash-flow (a truer measure of earnings) divided by the enterprise-value (a truer measure of the market-cap). This key metric allows me to instantly identify potential trade ideas, taking into account superior, more accurate metrics than the very basic, questionable stock-price and earnings-per-share. The objective is to identify and shortlist fundamentally robust, undervalued stocks which exhibit a high free-cash-flow-yield, relative to competing businesses within the same industry.
Wishing you every success in your trading… and good spirit…
Shiraz Lakhi – Independent Investor/Entrepreneur