When analysing companies, we often wonder what key metrics we should look at. Is it the net profit margin, the dividend yield, or is there another relevant measure we should be looking at? It also seems interesting from a finance theory point of view that, instruments such as bitcoin, gold or other commodities have almost zero value because they do not generate cash flows. In finance, we define the value of any asset as the present value of future free cash flow (FCF). And it is this value that investors should look for when investing in equities. So let's consider what this cash flow is and how to measure it, and which companies generate the most of it relative to current capitalisation.
Free cash flow is what generates value for investment
Values such as net profit or dividends have their limitations, which are worth bearing in mind. Firstly, net profit is a book value, which means that it may be susceptible to accounting manipulation. Secondly, the company may not pay dividends regularly or at all, which would distort its analysis over time.
To address these issues, the concept of so-called free cash flow can be used to help measure how much a company could actually pay out to shareholders based on the cash it generates. We can see this as a kind of 'virtual dividend' for shareholders. It takes into account different types of distributions, such as dividends, share buybacks, etc., while eliminating many accounting values, such as depreciation and amortisation, which can reduce net income. This allows the value of free cash flow to be a more reliable indicator of a company's ability to pay out to shareholders.
In the world of finance, the present value of future free cash flow appears to be important. Hence, there is a problem with determinations such as the value of gold, bitcoin and other assets. We are not always able to determine the value based on this, we often only measure the price.
The formula for calculating free cash flow to shareholders is very simple to apply and is as follows:
Source: https://stockanalysis.com/term/free-cash-flow/
This represents the amount of cash generated by the company's operating activities less capital expenditure on the purchase of new equipment and machinery (CAPEX). It is important to understand that negative free cash flow values are not always negative, as they can result from investment in the company's growth when capital expenditure is greater than operating cash flow.
Top S&P 500 index companies in terms of price to free cash flow (P/FCF) ratio
Ultimately, rather than relying on the most popular price/earnings ratio (C/Z), which is susceptible to a variety of factors, including accounting measures and the lack of consideration of distributions to investors, such as dividends or share buybacks, it is worth considering the use of the price/free cash flow (P/FCF) ratio. The interpretation is simple. The lower it is (positive), the higher the return to the investor. Of course, it is burdened by the fact that it is based on past values, so to select the best companies we will only include those whose analysts expect operating profit to grow by at least 5% over the next five years.
Principal Financial Group Inc. (Principal) is a company specialising in financial services, with a particular focus on the area of insurance and capital management in the United States. Currently, the company's P/FCF (Price to Free Cash Flow) ratio is 4.1, the lowest for companies in the S&P 500 index, with a projected earnings growth rate of 6.7%. It appears that the company, like the US financial industry as a whole, is experiencing a strong discount this year, which could create potential investment opportunities.
Source: Conotoxia MT5, Principal, Daily
In second place is US-based Northern Trust Corporation (NorthTrust), which specialises in asset management, custody and trust services, mainly for large corporations. It has a P/FCF ratio of 4.8 and a projected earnings growth rate of 8.9%.
Source: NorthTrust, Daily
In third place was leading steel and steel processing manufacturer Steel Dynamics Inc. (SteelDyn). The P/FCF ratio for this company is 5.8 and the projected earnings growth rate is as high as 28%. It is worth noting that SteelDyn is a company whose financial performance is heavily dependent on fluctuations in raw material prices, particularly steel prices, which is a key factor affecting its performance.
Source: Conotoxia MT5, SteelDyn, Daily
In fourth place is Expedia Group Inc. a US-based travel and online company. The company offers various services and platforms related to online travel and bookings, such as Expedia.com, Hotels.com, Orbitz and Travelocity. The company's P/FCF ratio is 6.25, with a projected earnings growth rate of 25%. The company is a direct competitor to platforms such as Booking and Airbnb, among others.
Source: Conotoxia MT5, Expedia, Daily
Fifth place goes to international insurance and reinsurance company Arch Capital Group Ltd. (ArchCapital). The company not only offers a variety of insurance products, but also provides reinsurance services, meaning that it indemnifies insurers against excessive risks in their insurance portfolios. This helps insurers effectively manage their risks and minimise potential losses. The P/FCF ratio is 6.6, with a projected average annual earnings growth rate of 19.7%.
Source: Conotoxia MT5, ArchCapital, Daily
If we compare the P/FCF ratio of these companies over time, we see that Northern Trust, Steel Dynamics and Expedia are particularly attractive in the context of the historical valuation of this ratio.
Grzegorz Dróżdż, CAI MPW, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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