Cashing in: Utilizing free cash flow for equity valuation

With traditional measures of equity valuations near historic highs, we introduce free cash flow as an alternative basis for valuation.

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September 13, 2021 | 12 minute read

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.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Andrew Korz, CFA

Executive Director, Investment Research

Robert Hoffman, CFA

Managing Director, Credit Wealth Solutions

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