We have found that no measurement tool which is foolproof, but the price to free cash flow ratio is a more reliable metric than the price-earnings ratio. The best way to get an accurate picture is to compare the relationship between free cash flow and net profit over a period of years, which is why Johnson and Johnson (JNJ) is a great example. This is due to factors such as the timing of payments, cash receipts and bulky capital expenses affecting the calculation. Just be aware that free cash flow can be volatile. Getting an Accurate Picture of Free Cash Flow This means that the company has more cash income than it spends on its growth and operations. We love to invest in companies which have positive free cash flow like Johnson and Johnson. It’s a mature company which continues to create incredible shareholder wealth by increasing profits, free cash flow and incredible returns on re-invested capital. One of our favourite companies is Johnson and Johnson (JNJ). There are instances where we may have to adjust this calculation because of the nature of the company. Take the amount of ‘net cash’ provided by operating activities and subtract the amount labelled ‘capital expenditure’ or ‘payments for property, plant and equipment’ (in other words, what the business spent purchasing new assets to maintain its operations). ![]() ![]() Look at a business’s cash flow statement in its annual report. How Free Cash Flow is CalculatedĬalculating free cash flow (FCF) is relatively simple. ‘Free Cash Flow’ is how much cash that is produced by a company to be utilized for paying dividends, reducing debt and buying back stock, after it has paid its debts, taxes and capital expenses.Ī business’ intrinsic value is the amount of cash that can be derived from a company for the duration of its existence. Let’s now try and explain this in more human language without too much use of financial jargon. It is the ‘Price to Free Cash Flow ratio’ (P/FCF). So instead of the P/E ratio, at The Freedom Trader, we like to use another metric that is simpler and more reliable. ![]() Net profit for companies that rely upon reinvestment for the maintenance and growth of their operations is often an exaggerated version of financial reality. It is much easier to manipulate income statements than balance sheets or cash flow statements.Īnother challenge we will find is how company’s smooth out big purchases like equipment and machinery as non-cash depreciation over many years. There are some companies with very creative accountants who decide how profits are reported. Be Mindful of Creative Accounting Practices However, relying upon these measures can lead us down the wrong path and lead to bad investing decisions. “If a stock’s P/E ratio is very low, is it cheap enough for me to buy?”Īn alluring Price to Earnings (P/E) Ratio can easily pull us as investors in, as can financial media that heavily focuses on net profit and its derivative.
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