The Price-to-Free Cash Flow (P/FCF) ratio a popular valuation ratio among value investors. It is similar to the P/E ratio but free cash flow is just operating cash flow minus capital expenditures. Because it relies on the Statement of Cash Flows, it is thought to be less susceptible to accounting manipulation. Free cash flow is also similar to Warren Buffett’s concept of Owner’s Earnings, which he uses to value companies. The P/FCF ratio is calculated as follows:
P/FCF = Market capitalization / Free Cash Flow
Let’s take a look at a backtest of this ratio to see how it works. I used the data and backtesting tool provided by Portfolio123. The Portfolio123 backtesting eliminates the problem of survivorship bias by using point-in-time and retaining data on stocks that have gone to zero. This backtest uses the same filtered universe of stocks as my recent PEG Ratio Backtest. I’ve designed the filtering criteria for this backtest specifically for individual investors and with a focus on enhancing data quality. The filters include the following criteria:
- No OTC stocks. Stocks not traded on the New York Stock Exchange, NASDAQ, or American Stock Exchange markets are excluded. The quality of fundamental stock data for OTC can be somewhat lower and less timely that that for stocks traded on major exchanges.
- No ADRs. Fundamental data for foreign American Depositary Receipt can include errors due to currency exchange, different accounting standards, and share count.
- Exclude the Financial Sector. The concept of free cash flow does not really work the same way for banks and other financial sector companies.
- Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000. This amount was selected so that a $1 million dollar portfolio could hold 100 positions and that each new $10,000 position would not exceed 10 percent of a day’s trading volume. The liquidity test also ensures that the backtest has reliable market price information for any of the stocks that are being tested.
- Market Cap > $50 million. Nano cap stocks are excluded to help improve data quality. This filter also ensures that positions in a modest sized portfolio never exceed one percent of shares outstanding or the available float for a company.
- Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks.
- P/FCF ratio > 0. This filter insures we are looking at stocks that actually have valid data on the P/FCF ratio.
After these filters are applied, we are left with approximately 1,300 to 1,900 stocks. These stocks are then ranked by the criteria being tested; in this case, we are testing the P/FCF ratio. The lowest 20 percent of stocks ranked by the P/FCF ratio are placed in the first quintile and the next 20 percent in the second quintile and so forth until we have five portfolios of stocks. The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. The following 5 charts display the quintile returns for the P/FCF ratio in red and the S&P 500 Equal Weight Index in blue. The first quintile includes the companies that had the lowest P/FCF ratios and the 5th quintile includes the companies that had the highest P/FCF ratios.
P/FCF Ratio Quintile Returns – 2000 – 2013
Summary of Results for the P/FCF Ratio Backtest
This backtest of the P/FCF ratio reveals that the first quintile outperforms the S&P 500 Equal Weight Index benchmark. The second through fifth quintiles have lower average annual excess returns than each of the previous quintiles and the overall trend in excess returns is a linear decrease as the P/FCF ratio increases. These results are as you would expect. The first two quintiles of the P/FCF ratio backtest outperforms the first two quintiles of the PEG ratio, and the last two quintiles of the P/FCF ratio has lower excess returns than the PEG ratio. Overall, the P/FCF ratio appears to outperform the more complex PEG ratio.
What are your thoughts on the P/FCF ratio?