Last updated on 18 July, 2023

Our examination extends beyond earnings and dives into the evaluation of a company’s free cash flow. This involves an assessment of the cash that a company is able to generate after laying out the money required for maintaining or expanding its asset base. It provides a useful measure for gauging the firm’s financial flexibility and its ability to generate shareholder returns. We perform an in-depth analysis of two specific metrics that provide vital understanding of a stock’s free cash flow potential:

Metric F1: Margin of Safety based on Free Cash Flow (MOS_F) – This measure offers a viewpoint on the “buffer” underneath a company’s current market price based on its free cash flow. A larger margin of safety connotes a greater degree of protection against uncertainties or market fluctuations.

Metric F2: Price-to-Free Cash Flow Ratio (P/FCF Ratio) – This ratio exhibits the amount investors are willing to pay for each dollar of the company’s free cash flow. A lower P/FCF ratio can suggest that the company is generating more cash flow relative to its market value and may therefore be undervalued.

Both of these metrics provide valuable insights into a company’s financial health and its ability to generate cash, which is crucial for funding operations, paying dividends, reducing debt, and making strategic investments.

We propose to delve deeper into these two metrics concerning Free Cash Flow below, with detailed examples. (The rest of this page is incomplete, as of 18 July, 2023)

Margin of Safety based on Free Cash Flow

Margin of safety can also be calculated based on a company’s free cash flow, which is the cash a company generates after accounting for capital expenditures. Free cash flow is an important indicator of a company’s financial health, as it provides insight into its ability to pay dividends, buy back shares, and invest in growth opportunities.

To calculate the margin of safety based on free cash flow, an investor may use the following formula:

Margin of Safety = (Current Free Cash Flow – Minimum Acceptable Free Cash Flow) / Current Free Cash Flow

The minimum acceptable free cash flow is the level of free cash flow that an investor is willing to accept based on their investment goals and risk tolerance. This can be determined by analyzing historical free cash flow growth rates, industry trends, and other relevant factors.

For example, let’s say a company has a current free cash flow of $100 million, and an investor’s minimum acceptable free cash flow is $75 million. The margin of safety based on free cash flow would be:

Margin of Safety = ($100 million – $75 million) / $100 million = 0.25 or 25%

This means that the stock would have a margin of safety of 25% based on free cash flow, which provides a cushion against potential losses.

References:

Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset. John Wiley & Sons.

Greenwald, B., Kahn, J., Sonkin, P., & van Biema, M. (2010). Value Investing: From Graham to Buffett and Beyond. John Wiley & Sons.

Murray, G., & Eccles, R. G. (2015). Simple Rules for Sustainable Business: A Practical Guide to Sustainable Strategy. Harvard Business Review Press.