In brief
Companies that produce increasing amounts of free cash flow can be naturally attractive to investors in search of stocks that are capable of funding future growth on their own. This bargain stock screen looks for investment candidates that are valued attractively against their free cash flow.
Background
In business education 101, the importance of free cash flow can hardly be overstated. Calculated by taking cash from operations and subtracting capital expenditure, the FCF shines a light on a company’s current cash position. Warren Buffett famously refers to it as “owner earnings”.
As opposed to traditional earnings, which may reflect sales that have yet to be paid for (depending on payment terms with customers), FCF reflects the real cash picture. To illustrate that point, it is possible for a company to produce positive earnings but negative FCF. Likewise, a company can be unprofitable but still have a positive cash flow. Neither is particularly desirable without the other over protracted periods, but without cash flow to pay bills, the company will likely be out of business fairly soon. Comparing the difference between the two is the basis of our very successful Accruals screen.
Free cash flow as an indicator in the search for stocks is particularly popular among bargain investors because it can offer a greater degree of accuracy in establishing a company’s intrinsic value – its real value as opposed to its market value. While other measures such as assets and earnings can ultimately be understated or even manipulated by crafty management, FCF is more transparent.
Using free cash flow as a valuation metric is a central philosophy of Bruce Berkowitz, a star fund manager at the US-based Fairholme Fund. His adherence to the bargain investing philosophies of Benjamin Graham sees him focus on companies with good management, positive free cash flow and are cheaply priced. Describing his approach, he claimed: “At Fairholme Fund, our trademark is we ignore the crowd. So we pay attention to what matters and what matters is cash. We count cash, ignore the crowd.”
How it works
The Free Cash Flow Cows screen looks for cash rich companies growing their FCF, yet selling at a cheap multiple to FCF. The screen is inspired by a methodology developed by Jae Jun on the excellent Old School Value US blog, who advocates the use of…
