The intended purpose of corporate financial reporting is to enable
investors to make informed decisions concerning securities selection.
But many investors and equity analysts there is much too much emphasis on reported and forecast GAAP earnings. The fact is that under GAAP a company can report positive earnings despite negative free-cashflow (FCF). Good examples are Enron, WorldCom and, today, Netflix.
Dividends and buybacks are funded by FCF, not GAAP earnings. GAAP earnings are pretty much useless in terms of actionable information content.
I focus on FCF, and my preferred ratio is FCF divided by market capitalization (FCF/MK) or, if you prefer, FCF per share divided by the share price. For many companies FCF can be volatile due to the bumpiness of capex such that one should use more than one year’s FCF to determine sustainability (and growth rate).
I periodicallytroll through Morningstar’s financial data on the lookout for companies meeting the following criteria:
High and reasonably stable (or growing) FCF/MK
Using these criteria I have identified the following names. Below are the tickers and the company’s recent FCF/MK rounded to the nearest %):
Before buying one of these I suggest:
Look at FCF volatility and growth rate;
Have some understanding of the company’s business model (sustainability of FCF);
Look for a non-capital-intensive business model;
Compare FCF to both assets and debt.
For comparison purposes, here is the data for the FAANG names which appear to be mediocre by FCF criteria (and, in the case of NFLX, radioactive).
The FCF/MK ratio does not measure long-term growth prospects which are to some extent conjectural and require much more in-depth analysis.