Free cash flow is a favorite parameter of value investors. It seems to make sense, because the value of a company is determined by how much cash it can generate over time. Value investors have developed discounted cash flow (DCF) models to estimate the value of companies.
While having free cash flow is essential for sustainable business operation, however, in our studies we have found that over the long term, stock prices are far less correlated with free cash flow than book value and earnings. In our 2008 study What Worked In The Market From 1998-2008? Intrinsic Value, Discounted Cash Flow And Margin Of Safety, we have found that stock prices are more corrected with earnings. That is why we use earnings per share and its growth rate for our DCF Calculator and Reverse DCF Calculator. In our recent Earnings, Free Cash Flow, Book Value? Which Parameters Are Stock Prices Most Correlated To? we found that stock prices are correlated much more closely to book value and EBITDA than free cash flow. Some more results are displayed below.
This is the price changes versus FCF changes from year 2000 to year 2012 for the companies in our database:
It can be compared with the price changes versus EBITDA changes and book value changes in the two charts below:
Calculation shows a far higher correlation between the stock prices and book values and EBITDA. Book value and price-to-book ratio were favorite parameters of Ben Graham. But they are largely ignored today. The reason might be modern investors rarely have opportunities to buy stocks at close to book value. EBITDA, a widely used parameter in private equity valuation, has been disdained by value investors. But it does seem to be a much better parameter than free cash flow.
Why are free cash flow and price-to-free-cash-flow ratio are poorly correlated with stock prices? Because free cash flow is subjected to many human-related variables. If we look at a company’s income statement and cash flow statement from top to bottom and compare the subjective variables in each step, we can see that free cash flow can be affected by many factors such as management’s decisions and accounting estimates. They are listed below:
If we look from the top to the bottom of the list, we can see that every item has subjective variables that can affect how much free cash flow a company can report. Free cash flow can be affected by many factors such as how revenue is booked, depreciation, management decisions on capital spending, inventory, etc. It can hardly be reliable if it depends on so many variables.
One may argue that parameters such as depreciation and amortization are added back in the calculation of cash flow from operations. But the amount that a company counted for depreciation and amortization affects how much tax it pays. Therefore it affects the net income, subsequently it affects cash flow from operations.
This can be seen more clearly if we look at a few examples. For instance, Wal-Mart (WMT, Financial) is a company with very predictable revenue and earnings, but its free cash flow is not nearly as predictable. This is the chart for Wal-Mart earnings per share and free cash flow per share over the years:
Apparently, management’s decision on expansion can affect Wal-Mart’s free cash flow drastically. Another example is Amazon (AMZN, Financial). The Wall Street darling is barely profitable, but its free cash flow paints a much better picture:
Where is Amazon’s cash flow from without earnings? Its depreciation and the changes of inventories.
In conclusion, while free cash flow is favored by value investors, it can be affected by many factors. It is not a very good parameter for stock valuation. The good old book value and price-to-book, while largely ignored these days, are much better valuation parameters.
While having free cash flow is essential for sustainable business operation, however, in our studies we have found that over the long term, stock prices are far less correlated with free cash flow than book value and earnings. In our 2008 study What Worked In The Market From 1998-2008? Intrinsic Value, Discounted Cash Flow And Margin Of Safety, we have found that stock prices are more corrected with earnings. That is why we use earnings per share and its growth rate for our DCF Calculator and Reverse DCF Calculator. In our recent Earnings, Free Cash Flow, Book Value? Which Parameters Are Stock Prices Most Correlated To? we found that stock prices are correlated much more closely to book value and EBITDA than free cash flow. Some more results are displayed below.
This is the price changes versus FCF changes from year 2000 to year 2012 for the companies in our database:
It can be compared with the price changes versus EBITDA changes and book value changes in the two charts below:
Calculation shows a far higher correlation between the stock prices and book values and EBITDA. Book value and price-to-book ratio were favorite parameters of Ben Graham. But they are largely ignored today. The reason might be modern investors rarely have opportunities to buy stocks at close to book value. EBITDA, a widely used parameter in private equity valuation, has been disdained by value investors. But it does seem to be a much better parameter than free cash flow.
Why are free cash flow and price-to-free-cash-flow ratio are poorly correlated with stock prices? Because free cash flow is subjected to many human-related variables. If we look at a company’s income statement and cash flow statement from top to bottom and compare the subjective variables in each step, we can see that free cash flow can be affected by many factors such as management’s decisions and accounting estimates. They are listed below:
| Parameter | Factors affecting the reported numbers |
| Revenue | How revenue is booked? When orders are received, product shipped, or payment received |
| Gross profit | How the costs of goods are accounted? First in first out? First in last out? |
| EDITDA | When employs are paid, how much to spend on marketing |
| EBIT (Operating Income) | How much to deduct for depreciation and amorization |
| Net income | Tax rate, interest payment, non-recurring profit or loss |
| Cash flow from operations | inventory variation, account payable, account receivables |
| Free cash flow | All of above plus Capital spending, acquisitions |
If we look from the top to the bottom of the list, we can see that every item has subjective variables that can affect how much free cash flow a company can report. Free cash flow can be affected by many factors such as how revenue is booked, depreciation, management decisions on capital spending, inventory, etc. It can hardly be reliable if it depends on so many variables.
One may argue that parameters such as depreciation and amortization are added back in the calculation of cash flow from operations. But the amount that a company counted for depreciation and amortization affects how much tax it pays. Therefore it affects the net income, subsequently it affects cash flow from operations.
This can be seen more clearly if we look at a few examples. For instance, Wal-Mart (WMT, Financial) is a company with very predictable revenue and earnings, but its free cash flow is not nearly as predictable. This is the chart for Wal-Mart earnings per share and free cash flow per share over the years:
Apparently, management’s decision on expansion can affect Wal-Mart’s free cash flow drastically. Another example is Amazon (AMZN, Financial). The Wall Street darling is barely profitable, but its free cash flow paints a much better picture:
Where is Amazon’s cash flow from without earnings? Its depreciation and the changes of inventories.
In conclusion, while free cash flow is favored by value investors, it can be affected by many factors. It is not a very good parameter for stock valuation. The good old book value and price-to-book, while largely ignored these days, are much better valuation parameters.
