Price to Free Cash Flow Backtest

Another favorite valuation ratios used by value investors is the price to free-cash-flow ratio (P/FCF). Instead of using earnings, this valuation ratio focuses on the cash flow statement results. It tries to approximate the value based on the theory that stock intrinsic value is based on the future free cash flows available to owners. Free cash flow is also closely related to what Warren Buffett describes as “owner’s earnings”, but instead of using maintenance capital expenditures, it uses current capital expenditures.

The price-to-free-cash-flow ratio for this backtest is calculated as follows:

P/FCF = current share price / trailing twelve month free cash flow per share
where free cash flow is equal to operating cash flow minus capital expenditures (CAPEX)

The disadvantages of this ratio is that it is not forward looking and free cash flows can be much more volatile than earnings, especially if there infrequent large capital expenditures that can impact the trailing twelve month free cash flows in the denominator of this ratio. The advantages of this ratio are that you do not have to forecast earnings or rely on analyst estimates and free cash flow numbers often avoid accounting issues with accruals that are used to smooth earnings. Free cash flows can often be more representative of what owners might be able to extract out of the company.

I decided to run a backtest of this ratio from January 2, 2000 to December 31, 2020 using annual rebalancing and dividing the universe of stocks into quintiles starting from highest P/FCF ratio to lowest (cheapest) P/FCF. I used my standard method of backtesting stock fundamentals on Portfolio123 that I described in an earlier article. The average excess returns for each quintile are displayed in the chart below. As expected, stocks with the highest P/FCF ratio in the first 20th percentile underperform the S&P 500 equal weight index by 0.87%. Stocks above the 80th percentile (5th quintile) with the lowest forward PE produce an average annual excess return of 2.39%. There is a fairly linear pattern to average excess returns as P/FCF decreases from the 1st quintile to the 5th quintile. However, the increase in average excess returns flattens out after the 3rd quintile.

Price-to-Free-Cash-Flow Ratio Average Excess Return by Quintile chart
Price-to-Free-Cash-Flow Ratio Average Excess Return by Quintile (2000 – 2020)

The full details of the backtest are in the table below.

Price to Free Cash Flow Ratio Backtest Results table
21-Year Backtest Results for the Price-to-Free-Cash-Flow Ratio (2000 – 2020)

Reviewing the average excess returns, we can see that the P/FCF ratio outperforms the PE ratio we tested last week and the forward PE ratio for the top quintile. The 1th quintile average excess returns were a bit lower for the PE ratio (-2.08%) than the P/FCF ratio (-0.87%).  I also noticed that the annualized return from January 2, 2000 to December 31, 2020 was 11.36% for the 5th quintile, which is lower than the annualized returns for the 4th quintile (11.36%), but only by a negligible amount.

P/FCF Ratio Top and Bottom Quintile Annual Excess Returns chart
P/FCF Ratio top and bottom quintile annual excess returns over time

It is interesting to note that the top quintile (lowest P/FC ratios) underperformed the bottom quintile over the past four years similar to the performance of the PE ratio and forward PE ratio. That seems consistent with the recent chatter on social media that value investing is dead. I’m not so sure I buy into that, but I just wanted to show you how that’s played out in the numbers.

Portfolio123 recently added several new valuation ratios including this revised price to free cash flow ratio. I’ll be backtesting several of those along with some old time standard valuation ratios over the next couple of weeks. Be sure to subscribe or follow along to get the latest updates.

2 thoughts on “Price to Free Cash Flow Backtest

  • May 10, 2021 at 5:05 am

    Good article George. I agree that value investing is not dead but the past few years was just a period in which it underperformed.

    We also looked at back tests of Free Cash Flow. And also back tested it defined as Free Cash Flow / Enterprise Value.

    In two back tests FCF performed very well, in one test second only to EBITDA/EV.

    We also found that you could have increased the return from a FCF investment strategy by 506.3% over 12 years if you added momentum.

    You can see all he results here:

  • May 27, 2021 at 6:12 am

    Based on the last graph, The top quintile’s excess return seems to be deteriorating overtime, and the bottom’s slightly rose over the last several years.

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