Investors are beginning to see free cash flow of companies as a key indicator of future profitability and investment opportunities, money managers say.
Free cash flow — a measure of a company's liquidity — is increasingly being looked at by investors compared to traditional measures of equity return prediction such as price-to-book or price-to-earnings ratios.
How companies are deploying free cash is becoming a much more reliable metric to evaluate equities. Industry sources said historical analysis of a company's free cash flow is a more dependable guide to profitability and stock price valuation over a five- to 10-year term than forecasts produced by sell-side brokers and company executives.
In addition, the rise of cash-rich companies make a traditional stock valuation approach flawed because companies can end up with negative earnings but positive free cash flow and vice versa.
Bob Collie, head of research at Willis Towers Watson PLC's Thinking Ahead Institute in London, said too much free cash flow traditionally "wasn't a problem that a lot of companies had. But it has now become a key to the strategy for these (investee) companies. In theory, this could have always been something that needed to be analyzed but the reason it is a big deal now is because some companies are extremely cash rich."
Cash-rich companies juggle different purposes for their extra cash flow, including dividends or mergers and acquisitions, which could alter how investors view them in their portfolios. Increasingly, these companies operate asset-light business models and won't require additional cash to support the manufacturing of goods, for example.
These companies also are less dependent on capital market financing or less susceptible to macroeconomic forces because they have the resources to ride out turbulence.