What it means
Free cash flow is the cash a business generates from operations minus what it must spend on capital items such as machinery, buildings and systems. It is the cash that could, in principle, be used to pay dividends, buy back shares, repay debt or fund acquisitions.
Unlike accounting profit, it is hard to flatter with accounting choices. The ratio divides the market value of the company by its free cash flow, or equivalently the share price by free cash flow per share.
A result of 10 means investors are paying $10 for every $1 of annual free cash flow. Turned upside down, it becomes the free cash flow yield, which is easier to compare with interest rates.
Analysts like the measure because earnings can differ widely from cash, especially in companies with heavy spending on equipment or large swings in working capital. A business with strong reported profit but weak free cash flow may be tying up cash in stock or unpaid customer invoices.
The ratio exposes that gap. Care is needed in how free cash flow is defined, since some firms add back stock-based pay or exclude certain investments.
Compare companies in the same industry and using the same definition. A fast-growing business may show a high ratio because it is investing heavily today, which is not necessarily a bad sign.
The ratio also swings if one year's cash flow is unusual, for example after a large customer prepayment. Using an average over several years often gives a steadier picture than a single year.
Managers can influence the ratio by managing cash well, for example by collecting customer invoices promptly, holding sensible stock levels and timing large purchases carefully. Those habits raise free cash flow without any change in reported profit, and the market tends to reward the improvement.
In practice
Real-world examples.
Example
An investor compares two packaging companies with similar profits. One has a price to free cash flow of 9 and the other 22, and on inspection the second spends heavily on new plants every year, which explains the gap.
Example
A private equity buyer looks at a services firm priced at 12 times free cash flow. The buyer works out whether the cash is enough to repay the acquisition debt within seven years.
Example
A chief financial officer sees her own company's ratio rise from 11 to 16 after the share price climbs. She notes that cash flow has not changed, so the market now expects growth rather than paying more for current cash.
Formula
Calculation
Price to free cash flow = Market capitalisation / Free cash flow, where Free cash flow = Operating cash flow - Capital expenditure.
A manufacturer has a market capitalisation of $900,000,000. Its operating cash flow for the year is $120,000,000 and it spends $30,000,000 on equipment. Free cash flow is $120,000,000 - $30,000,000 = $90,000,000.
Price to free cash flow is $900,000,000 / $90,000,000 = 10. The free cash flow yield is the reverse: $90,000,000 / $900,000,000 = 10%. A competitor with a ratio of 25 has a yield of only 4%, so the first company looks cheaper unless the competitor is growing much faster. If the first company's capital spending doubled to $60,000,000, free cash flow would fall to $60,000,000, and the ratio would rise to $900,000,000 / $60,000,000 = 15 with the share price unchanged.Case study
Seen in the real world.
Meridian Components is a fictional supplier of machine parts. In an illustrative review, an investor found that its profit had grown steadily for four years, yet its price to free cash flow had climbed to 40 because free cash flow had barely moved.
Digging into the accounts, the investor saw that unpaid customer invoices and unsold stock had grown faster than sales. The profit was real on paper, but the cash had been tied up in working capital.
The fictional finance team then introduced tighter credit terms and a stock reduction programme. Over the next year free cash flow doubled and the ratio fell to 20, which showed how the measure picks up cash problems that profit alone can hide.
Watch out
Common mistakes.
- Using profit and free cash flow interchangeably, when the two can differ widely because of timing and investment.
- Comparing ratios across industries with different investment needs, such as software and heavy manufacturing.
- Assuming a low ratio is always a bargain, when it may reflect a business in decline.
Questions
People also ask.
What is a good price to free cash flow?
There is no single answer, because it depends on the industry and growth, but a lower figure suggests you pay less for each dollar of cash.
Is it the same as the free cash flow yield?
It is the inverse: divide 1 by the ratio to get the yield.
Can free cash flow be negative?
Yes, when capital spending exceeds operating cash flow, and then the ratio is not meaningful.
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