I've recently written about a couple of valuation metrics for Drippers: the price-to-earnings ratio and free cash flow. Many readers are already familiar with these topics, in large part because Jeff Fischer incorporates them into every buying decision for the Drip Port.
I pointed out that free cash flow (FCF) is superior to reported earnings for measuring a company's true profitability, because the earnings number can be manipulated too easily. And so it follows that price-to-free cash flow (P/FCF) is preferable to price-to-earnings (P/E). After my columns, I received the following email:
I am reasonably knowledgeable about 'normal' P/Es for different sectors of the market, but very ignorant about what should be expected in terms of P/FCF. I wonder if you would consider a follow-up article, giving an idea of what you would look for in a selection of different companies -- say, a house builder, retailer, engineer, chip maker, drug maker, etc. It is often said we should be wary of companies with a P/E over a certain number: Is it the same for P/FCF? The point is, I would like to become as familiar with P/FCF as I am with P/E.
Since one of our Drip holdings, Johnson & Johnson (NYSE: JNJ), recently released its second-quarter 10-Q, let's dig into that to calculate its P/FCF, and then address the email questions by comparing the company to its peers.
Looking on the cash flow statement, we see that J&J generated nearly $3.5 billion in cash from operations for the six months ended June 30. That compares to about $3.9 billion for the same period in 2001, or a drop of 10%. To find out what happened here, I read through the "Management's Discussion and Analysis" section of the 10-Q and found this under "Liquidity and Capital Resources":
Cash generated from operations and selected borrowings provides the major source of funds for the growth of the business, including working capital, additions to property, plant and equipment, acquisitions, and stock repurchase programs.
After stating the importance of cash from operations, management explained the decrease was the result of "a change in the timing of salary increases and bonuses to employees." If true, then we know there's nothing to worry about regarding ongoing operations. The business itself did not suffer a 10% hit.
Now, to figure out our FCF number, we simply subtract additions to property, plant and equipment (capital expenditures) from cash from operating activities. FCF for the six-month period was therefore $3,493 - $802 = $2,691. Since the dollars are all in millions, we add six zeroes and arrive with an FCF of about $2.7 billion.
For purposes of calculating P/FCF, however, we want FCF for the past 12 months, not six. Yahoo! (Nasdaq: YHOO), which has quarterly numbers listed, can help. All we have to do, then, is add up the past four quarters for J&J, and we get a total of $8.4 billion in cash from operations and $2 billion for capital expenditures. That gives us an FCF of $6.4 billion over the past 12 months.
Now we can move on to calculating P/FCF. J&J's market capitalization -- the value of all shares outstanding -- is $164.8 billion. If we divide that by $6.4 billion, we have a P/FCF of 25.75.
Armed with that number, we can now see how J&J stacks up against its peers. I pulled out the P/FCF for several direct and indirect competitors and found a fairly tight range:
Company Est. 5-yr. P/FCF P/E sales growth Johnson & Johnson 26 28 8.9% Schering-Plough 23 18 9.4% Amgen 33 40 11.5% Merck 17 16 17.3% Abbott Labs 21 14 7.2% Pharmacia 37 39 14.6% S&P 500 24 22* -- *excludes companies with negative earnings
J&J's P/FCF of 26 is certainly in the ballpark, and this is where we get to the crux of the email question. Is 26 a "good" number for a pharmaceutical giant? Why is Pharmacia at 37 and Merck at 17?
This is a good example of why extensive due diligence is so important when considering a company as an investment. There are many reasons P/Es and P/FCFs vary from company to company. Perhaps those with lower values are expected to grow more slowly than those with higher values, for instance. Perhaps there has been some change in the company recently. Pharmacia, for example, recently spun off agricultural subsidiary Monsanto. While now it's more of a pure-play pharmaceutical, its past financials don't reflect that.
Finally, there may simply be an inefficiency in the way the market is valuing the companies. If all of your research indicates two of these pharma giants have largely identical prospects, yet one has a significantly lower P/FCF, then maybe you've found an inefficiency you can exploit.
This is very similar to one of the factors Jeff Fischer uses when deciding which company gets more Drip dollars. Jeff tracks the historical P/Es for his Drip holdings, and when it's time to mail a payment, he usually goes with the company that's trading closest to the bottom of its historical range on a forward basis. It's just another way of buying a company when it appears to be valued favorably.
We can tie all this together by addressing the final part of the email: What is a good P/FCF for a company? As you probably gathered from the J&J analysis, there's no simple answer. (There's never a simple, single answer in investing.) A certain number isn't especially magical. But there are some things you can do to help give you perspective.
First, you need to know what other companies within the same industry are trading for. (Don't try to make comparisons of companies in different industries on a P/FCF basis.) Making a chart like the one above will help you. Second, try to track a company's P/FCF and P/E range over a period of time. You'll get an idea of when the price is getting into a more favorable range.
The best way to become as familiar with P/FCF as you are with the P/E is to simply start using it regularly. It may take more effort at first, but soon it'll be second nature!