What Free Cash Flow Tells You — With 16 Cheap Stocks

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The price to free cash flow ratio indicates whether a company is able to reward impatient shareholders.

Written by Hyunsoo Rim and Segun Olakoyenikan; Edited by William Baldwin

Yesyou knew Tesla is expensive: it trades at 63 times past year earnings. Did you know its cash flow multiple is an even bigger outlier, 10 times P/E?

The aforementioned ratio is price divided by free cash flow. It compares the market value of common stock to the loose cash generated by the company. A low ratio is a sign that the company is cheap.

The P/FCF ratio is similar to the price/earnings ratio. However, free cash flow can be very different from earnings. A company can post large profits without being able to raise cash. The money it earns is reinvested in the business, either to replace aging equipment or to expand. Such companies may be reasonably valued on a P/E basis, but look quite expensive on a P/FCF basis.

Tesla’s $12 billion profit in the 12 months to June 30 wasn’t bad, but it had significantly less in the coffers as the company wound down its capital spending. Tesla is investing most of its profits in new factories, artificial intelligence and a stockpile of leased cars. It doesn’t pay a dividend. The stock is a pure growth story. Two birds in a bush.

Celanese Corporation is a pretty big contrast, cheap both in terms of earnings and the cash it generates. Its earnings are the kind you can take to the bank: use them, in a shareholder-friendly way, to pay dividends, buy back stock, or pay down debt. Growth is not very exciting. Instead, shareholders have a bird in the hand.

What is free cash flow? In the simplest analysis, you add back the depreciation expense to net income and then subtract the capital expenditure. If the depreciation charge used to calculate net income is greater than the amount spent on property additions, the free cash flow will be higher than the net income. This is the type of company that is set up to pay a good dividend.

A more precise definition starts with the amount of “cash provided by operations” on the financial statements. To get to cash from operations, accountants add to net income noncash charges for asset depreciation, goodwill amortization, and the paper cost of employee stock options. Then they factor in changes in working capital that either absorb or free up cash. An increase in accounts receivable (caused by customers not rushing to mail a check) reduces cash from operations; an increase in accounts receivable increases cash.

Now subtract capital expenditures. It’s some mix of what’s needed to keep existing customers from leaving and what’s needed to generate growth. In the first category: replacing outdated tools or blockbuster movies from years past or shrinking oil wells. In the second: some of Tesla’s new “gigafactories.” In the latest quarter, Tesla generated $3.8 billion in cash from operations, but spent $5 billion on real estate, plants, and equipment. It borrowed money to keep operating.

The cash flow statement in the annual report usually does not distinguish between maintenance and expansion. There is usually only a sum of capital expenditures. Investors have no choice but to subtract the lump sum of capital expenditures and use the resulting free cash flow figure, along with a number of other indicators (such as revenues), to assess whether they are buying a company that is growing or one that is moving quickly to stay in business.

Like the P/E ratio, the P/FCF ratio has its limitations. The ratio spikes or becomes meaningless when its denominator is small or negative. Different data sources use different definitions of the variables. The ratio can be quite volatile: Morningstar calculates that Netflix’s price-to-cash-flow ratio was 417 in 2021 and 36 in 2023.

The table highlights cheap companies that have a low cash flow multiple and a low earnings multiple in the YCharts database. Below that are expensive companies with high and significantly higher P/FCF than P/E.

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