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Free Cash Flow Valuations: Which Are The Companies With Deep Pockets
Education | 12 August 2011
By: jason.liew
Articles (66) Profile

Cash is king! This statement holds true for a business in the availability of good investment opportunities. In an economic downturn where funds are limited in the capital markets, cash offers protection for a company’s working capital needs.

On the contrary, too much of cash kept in a company could over time loses its value in the presence of inflation. Excessive cash could also be a signal that the management of the company has run out of investment ideas.

Nonetheless, the amount of cash available in a company is a good indicator of its financial health, and is commonly referred by the performance measure termed free cash flow, which allows a company to undertake opportunities and enhance shareholders’ value. With cash, an aspiring company could develop new products, embark on merger and acquisition opportunities, pay dividends, and even reduce its debt.

In this article, we explored the various valuation metrics as well as a list of companies with the lowest price-to-free cash flow ratio beginning with the basics.

Free Cash Flow And Its Ratios

Free cash flow shows the amount of cash remaining in a company after taking into account its capital expenditure. The deduction of cash dividend is a more conservative approach in deriving the free cash flow.

Each valuation metric in Table 1 tells a different story. Price-to-free cash flow ratio is one of the value investing methods to compare a company’s market value against its free cash flow. Free cash flow is widely seen as a better performance indicator than earnings as the former is not easily manipulated.

Free cash flow yield is a representation of the cash returns shareholders receive in the ownership of the business. Another way of calculation is using the market capitalisation, in place of the enterprise value. The use of market capitalisation is, however, regarded as a less accurate measure of a company’s worth. The amount of cash generated from a company’s revenue can be determined using the free cash flow-to-sales ratio. When performing a credit analysis, the free cash flow-to-debt ratio can be used to ascertain a company’s debt servicing ability to finance its borrowings.

Value Stocks
Table 2 shows a list of 20 companies with the lowest price-to-free cash flow ratio ranked in ascending order. The lower the ratio, the cheaper the stock is considered. Other valuation metrics are presented to show a broader picture of the companies’ performance.

When deciphering the information in Table 2, particular attention must be given to the anomalies. There are three companies with negative free cash flow yield which may indicate that the companies are having difficulties in generating sufficient cash to support its businesses. There are exceptional cases where a large amount of cash is pumped into investments and projects, which will bring the free cash flow yield to a negative value. It is in the investors’ discretion to evaluate on the future value of such investments. Looking at the free cash flow-to-sales column, Blumont Group, Hiap Hoe, and IFS Capital are in the top list in generating cash out of its revenue.

Distinctly, companies with a “-” sign in the free cash flow-to-debt ratio have zero long-term and short-term debt. Amongst the companies with large amount of cash to finance their debt are Blumont Group, Unidux Electronics and Lum Chang Holdings with relatively high free cash flow-to-debt ratios.

Bottom line, investors should observe the way companies manage cash and how effectively is the cash used to benefit its shareholders. Like all valuation metrics, free cash flow has its limitations and should be supplemented with other methods of value based fundamental analysis before making an investment decision. Nevertheless, performance analysis using free cash flow is a good starting point.

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The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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