Equity markets have soared since the early days of the pandemic, bringing valuations into sharp focus. Earnings-based metrics, the most popular and widely tracked measure of a company’s valuation, are near historic highs. We introduce free cash flow (FCF), a measure of corporate profitability that is less widely cited but has significant advantages over accounting-based net income. In our view, free cash flow should form the basis of an investor’s valuation framework.
Investors, analysts, and the financial press have historically focused on earnings, or net income, as the primary metric for assessing a company’s performance. Analysts forecast earnings per share (EPS), management teams speak at length on the topic in their quarterly earnings calls, and markets move based on earnings beats and misses. This would appear logical given that net income is the result of combining all revenues and expenses over the previous period based on Generally Accepted Accounting Principles (GAAP) accounting practices. However, earnings can be a flawed metric and basing valuations solely on it may lead to problematic or incomplete analysis. In our view, FCF is a more useful metric in measuring the performance of a company over time and, ultimately, represents a better input for an investor’s valuation framework. In fact, a historical strategy of investing in stocks in the top quintile of FCF yield would have produced returns well in excess of the broader market, further exemplifying the metric’s significance.
Key takeaways
- FCF may provide better insight into a company’s fundamentals than the more commonly cited net income.
- Driven in large part by the tech sector, firms are producing more FCF than ever, pushing margins upward.
- FCF yield provides a more useful valuation framework than more popular metrics such as P/E ratio and price-to-book.
- Investing in stocks with high FCF yields has historically delivered performance superior to other value factors.
