Price to free cash flow is a valuation indicator that compares current stock price with all the cash available after capital expenditures. It is expressed as a ratio dividing market capitalization by free cash flow.
Price/Free Cash Flow = Market Capitalization / Free Cash Flow
Since the free cash flow is already freed from capital expenditure (CAPEX), it provides an information how much money can be used for non-asset related activities. Thus, companies with cash in hand are able to enhance their operations and consequently increase revenue. Therefore, the price to free cash flow is an important fundamental indicator that measures company’s ability to create additional growth.
Investors use the ratio to value the company and thus, lower the ratio – more undervalued the stock is – higher growth potential in future. The price to free cash flow ratio plays a significant role in trend trading theory. We are trying to spot a trend with strong properties and soon enough. Thus, the current ratio of the stock should be perhaps smaller – under 20! Since the trend is a continuous element, it is beneficial when the ratio is decreasing.
For instance, Jones Lang Lasalle Inc. had its Price/Free Cash Flow ratio very high in March 2017 and wouldn’t apply in our stock selection strategy until September when the ratio decreased below 20. The company has improved its price to free cash flow and further analysis can be done. The ratio has been decreasing quarterly, which is another good sign of stronger trend for the stock that is undervalued.
Considering all other fundamental and technical analysis are suitable for the stock selection, the price/free cash flow ratio suggested an entry point in September 2017. Below chart shows an established trend since the beginning of 2017. Since September the stock has risen by 50%.
Note, the Price to Free Cash Flow must not be used as the only indicator when picking the stock. It must always be accompanied by other fundamental indicators because there are also other aspects of the firm's engine that drives profitability and valuation.