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May, 2017


What could be better than free money, right? Low Price to Free Cash Flow (P/FCF) is considered a useful alternative to Low Price to Earnings (P/E) for evaluating possible value in stock purchase candidates. Earnings can be more easily manipulated by management to make the P/E look good. The stock of a successful, growing company often can be evaluated by several value criteria, such as the growth of its dividends, earnings, sales, and free cash flow. Ideally, all will similarly reflect progress in adding value for shareholders. Yet if there is a discrepancy, the P/FCF is usually more reliable than other measures. Free cash flow is defined as that extra stream of dollars generated by a company's profitable activities after subtracting normal capital expenses and shareholder dividends. Price to Free Cash Flow, then, is the price per share divided by the per share free cash flow. The lower this ratio, the more easily beneficial changes can be made by management, hence increasing the stock's value. These might include increasing the dividend, further reducing company debt, repurchasing stock when it is selling below intrinsic value, buying up smaller businesses whose operations can help add to the company's bottom line, upgrading plant and equipment, etc. Companies that generate more free cash flow for their market price are also attractive to potential buyers of the entire corporation. Such subsequent mergers and acquisitions often lead to nicely profitable prices per share being paid to shareholders . All things being equal, then, it is better to have holdings in a company with low P/FCF.

Consistent with this, the American Association of Individual Investors (AAII), which tracks dozens of investment strategies, has found that its low P/FCF screen generates higher gains for investors than most, in fact through the most recent reporting period, 3/31/17, providing 18.1% average yearly total returns (before commissions, but including dividends) since the screen's early 1998 inception. This compares well with the S&P 500 Index record of 4.2% for the same period.

Express Scripts Holding CompanyESBX$61.027.620.00%
McKesson Corp.MCK$143.235.700.80%
Michael Kors Holdings, Ltd.KORS$38.236.760.00%
Molina Healthcare, Inc.MOH$68.163.500.00%
Teva Pharmaceutical Industries, Ltd.TEVA$31.3610.583.70%
United Therapeutics Corp.UTHR$123.488.040.00%

The mean P/FCF for U.S. stocks is about 14. P/FCF values significantly below this are considered low and overall have greater potential for profitability. The table shows several companies with recently low P/FCF ratios and can be filtered further as desired for the better investment candidates. My own favorites at this time are MCK and TEVA.

Though it can be a helpful starting point in evaluating purchase candidates, the low P/FCF criterion is of course but one tool in the investor's kit. Warren Buffett suggests that folks who do not wish to evaluate stocks carefully would be best served simply buying on a dollar-cost-average basis low fee stock index mutual funds. Good advice, in my view. For those who do wish to be more active in equity analysis, however, the Price to Free Cash Flow ratio can be quite useful.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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