Free cash flow (FCF) or earnings per share (EPS): which is the better measure of company profits? Like everything, it depends on who you ask, and what you’re looking for.
Reputationally, executives like to focus on EPS because it offers more discretion around the timing of revenue and income recognition, while helping to smooth the distorting effects of working capital. Cynically, one could also argue that those in the C-suite pay more attention to earnings because their bonuses tend to be linked to EPS targets.
Some outspoken investors, by contrast, lean towards FCF. This is in part because the cash flow statement is harder to manipulate and gives a clearer picture of the cash left over for shareholders after a company’s total growth spending, interest costs and other overheads are factored in. Again, if one were being cynical, you could say that this results in an overly narrow view of company performance and direction and reduces the options open to management into a conversation about the cash available for buybacks and dividends.
Analysts, nominally tasked with interpreting the former group for the benefit of the latter, sit somewhere in between, although in my experience, they often prefer EPS for two reasons.
First, the difficulties of forecasting and modelling free cash flow complicate its use as a reliable metric in valuing companies – which after all is a big reason why investors pay attention to analyst scribblings. Second, the lumpier nature of free cash flows means they aren’t always a great way to analyse standalone financial statements.
For example, a big step up in BT (BT.A)’s capital expenditure since 2020 served to suppress free cash flow to £301mn and £555mn in the 12-month periods to March 2021 and 2022, respectively. Given these figures are far short of the past decade’s average of £1.4bn, and the fact that FCF clocked in at £1.5bn in FY2020 (and a mere £70mn the year before), it is clear why cash is sometimes used more as a sense check than a lead metric for the purposes of valuation or analysing any one set of results.
All of which brings us, somewhat circuitously, to this week’s US Cash Magic screen.
The stockpicking method – a direct adaptation of our successful and long-running UK version – is designed to search for S&P 500 companies whose stated and forecast cash flow figures point to a good blend of business quality and cheapness. Its inaugural appearance was last April, meaning it has been in service for a little less time than is normal for our annual refreshes. However, owing to an extended period of leave later this year, I am expediting the screen running list for now.
While events may change over the coming month – particularly if the past week’s market drama persists – the good news is that the screen performed remarkably well in its first outing.
The word "remarkably” requires a bit of context. While both versions of the screen (more on this below) outperformed the S&P 500 by at least 10 percentage points, neither was that far into positive territory. But both the dispersion of returns from last year’s 30 selections (half were up on a total return basis) and the level of alpha suggest to me that signs of growing or resilient free cash flow really were at the forefront of investors’ minds for much of the past year.
| Company | TIDM | Total return (11 Apr 2022 - 9 Mar 2023) |
| Tapestry | US:TPR | 27.90 |
| Biogen | US:BIIB | 22.97 |
| Nvr | US:NVR | 22.74 |
| Cardinal Health* | US:CAH | 18.88 |
| Kla | US:KLAC | 15.70 |
| Conocophillips* | US:COP | 12.88 |
| Autozone* | US:AZO | 12.22 |
| Nucor* | US:NUE | 11.31 |
| Occidental Petroleum* | US:OXY | 5.50 |
| Mckesson* | US:MCK | 5.39 |
| Lam Research | US:LRCX | 4.20 |
| Interpublic | US:IPG | 4.11 |
| Masco | US:MAS | 4.03 |
| Hologic* | US:HOLX | 2.57 |
| Applied Mats | US:AMAT | 1.67 |
| Lowe's | US:LOW | -0.75 |
| UPS | US:UPS | -0.91 |
| Lyondellbasell* | US:LYB | -0.91 |
| Cisco Systems | US:CSCO | -5.26 |
| Devon Energy* | US:DVN | -6.12 |
| Dow* | US:DOW | -6.54 |
| APA* | US:APA | -8.23 |
| Abbvie* | US:ABBV | -9.91 |
| Bristol Myers Squibb | US:BMY | -11.08 |
| Qualcomm | US:QCOM | -11.39 |
| Best Buy | US:BBY | -13.11 |
| Moderna | US:MRNA | -14.15 |
| Netapp | US:NTAP | -15.86 |
| Seagate Technology | US:STX | -22.49 |
| CF Industries* | US:CF | -23.01 |
| S&P 500 | - | -9.78 |
| US Cash Magic | - | 0.75 |
| US Cash Magic Momentum | - | 0.21 |
| *Appeared in both momentum and cash magic screens. | ||
Although the US Cash Magic screen(s) pulled ahead of the benchmark shortly after we started tracking the stocks in April, it wasn’t until the rebound from October’s market lows that solid free cash flow became a must-have attribute. Another way of looking at this is that value stocks, particularly in sectors whose cyclicality has proved less sensitive than feared, have held up well.
“In the short run,” Benjamin Graham famously said, “the market is a voting machine but in the long run, it is a weighing machine”. What the noted value investor meant by this is that a company’s actual long-term cash generation, rather than the prevailing investor optimism or sentiment about those cash flows, ultimately determines the value of its shares.
Over the past 18 months, we have witnessed something akin to a reversal of this logic, as wild speculation and optimism about the future has given way to the magnetic pull of higher interest rates and tougher trading conditions. As businesses’ capital costs and attendant risks have climbed, markets have been more urgent in their demand to see the money.
If the US Cash Magic screen is reflective of this pivot – and the past year’s evidence suggests it might be – then oil and gas stocks could once again be in favour. Thirteen of this year’s selections, from regional drillers to supermajors, hail from the energy sector, compared with just four in 2022. None trade on more than 10 times forward earnings, suggesting little in the way of bullishness about sustained profitability in the years ahead. However, most also boast double-digit forecast FCF yields, pointing to some optimism that last year’s strong cash generation will continue in 2023.
Myopic as that implied outlook might prove, it seems fitting both for today’s market conditions and a hypothetical portfolio whose constituents are reshuffled once a year.
The methodology
Our Cash Magic screens combine three hallmarks of value, quality and momentum investing.
In the US version, all S&P 500 constituents are ranked by forecast next 12-month FCF yield (FCF per share as a percentage of share price). They are separately ranked by cash return on capital invested (CROCI). This ratio, originally developed by Deutsche Bank analysts in the 1990s, measures how much FCF a company produced for every dollar of capital employed over the past year. The two rankings are added together into a combined score, which gives a final ranking.
For the ranked version of the screen, the top 30 stocks are selected. Stocks whose three-month share price momentum exceeds the index median are also highlighted and will be separately tracked over the coming year. This allows us to add a ‘run-your-winners’ factor to the results.
The stocks selected by this year’s screen can be found below:
| Rank | Company | Ticker | Sector | Mkt Cap ($mn) | Price ($) | Net Debt/EBITDA | Fwd NTM PE | Fwd FCF yld | CROCI | PEG | EV/FCF | 3-mth Momentum |
| =1 | APA | US:APA | Energy | 11,508 | 37.01 | 0.83 | 5 | 15% | 56% | 0.21 | 4.54 | -21.0% |
| =1 | CF Industries | US:CF | Non-Energy Materials | 15,879 | 81.11 | 0.14 | 8 | 18% | 45% | 0.32 | 4.53 | -25.0% |
| 3 | Valero Energy* | US:VLO | Energy | 49,096 | 132.28 | 0.40 | 6 | 18% | 32% | 7.87 | 4.55 | -1.0% |
| 4 | Marathon Petroleum* | US:MPC | Energy | 57,199 | 128.38 | 0.70 | 7 | 18% | 27% | 0.29 | 4.96 | 5.4% |
| 5 | Expedia Group | US:EXPE | Consumer Services | 14,901 | 100.80 | 0.33 | 10 | 10% | 35% | 0.43 | 5.05 | -5.7% |
| 6 | ConocoPhillips | US:COP | Energy | 128,959 | 105.81 | 0.24 | 10 | 13% | 29% | 0.37 | 6.25 | -14.3% |
| 7 | Marathon Oil | US:MRO | Energy | 15,477 | 24.58 | 1.08 | 6 | 20% | 24% | 0.63 | 4.51 | -19.8% |
| =8 | McKesson | US:MCK | Healthcare | 46,007 | 335.97 | 1.06 | 13 | 8% | 85% | 1.05 | 9.15 | -12.0% |
| =8 | Coterra Energy | US:CTRA | Energy | 19,291 | 25.11 | 0.26 | 9 | 16% | 25% | 0.29 | 4.83 | -10.0% |
| 10 | Pioneer Natural Resources | US:PXD | Energy | 47,476 | 202.02 | 0.35 | 9 | 11% | 26% | 4.86 | 6.25 | -14.4% |
| =11 | Cardinal Health | US:CAH | Healthcare | 18,367 | 71.29 | 0.69 | 12 | 7% | 96% | 5.21 | 5.77 | -11.1% |
| =11 | Cisco Systems* | US:CSCO | Technology | 199,917 | 48.81 | - | 12 | 9% | 31% | 1.55 | 10.03 | -1.8% |
| 13 | AbbVie | US:ABBV | Healthcare | 260,721 | 147.35 | 1.77 | 13 | 9% | 33% | 3.92 | 9.99 | -8.6% |
| 14 | Exxon Mobil* | US:XOM | Energy | 449,429 | 109.13 | 0.19 | 10 | 10% | 24% | 0.65 | 6.86 | -2.0% |
| 15 | QUALCOMM | US:QCOM | Technology | 130,700 | 117.22 | 0.57 | 11 | 9% | 24% | 2.97 | 13.62 | -7.3% |
| 16 | NetApp | US:NTAP | Technology | 13,562 | 63.40 | - | 11 | 8% | 29% | 1.81 | 10.42 | -6.2% |
| 17 | Lowe's | US:LOW | Consumer Cyclicals | 120,366 | 199.05 | 2.86 | 14 | 7% | 33% | 0.71 | 17.11 | -6.4% |
| 18 | NVR* | US:NVR | Consumer Cyclicals | 16,964 | 5,308.12 | - | 14 | 7% | 42% | - | 7.58 | 14.4% |
| =19 | AmerisourceBergen | US:ABC | Healthcare | 30,339 | 150.00 | 1.13 | 12 | 6% | 42% | 1.80 | 12.80 | -12.1% |
| =19 | Phillips 66 | US:PSX | Energy | 47,802 | 101.14 | 1.03 | 7 | 14% | 19% | 0.37 | 5.86 | -6.7% |
| 21 | Diamondback Energy | US:FANG | Energy | 25,692 | 139.94 | 0.79 | 6 | 11% | 21% | 0.44 | 5.82 | -5.5% |
| 22 | Devon Energy | US:DVN | Energy | 34,649 | 52.98 | 0.49 | 7 | 11% | 21% | 0.31 | 8.94 | -22.7% |
| =23 | Chevron | US:CVX | Energy | 306,040 | 160.51 | 0.15 | 10 | 10% | 21% | 1.43 | 6.83 | -12.4% |
| =23 | Booking* | US:BKNG | Consumer Services | 94,324 | 2,505.39 | 0.14 | 19 | 6% | 41% | 0.85 | 12.91 | 20.5% |
| 25 | Bristol-Myers Squibb | US:BMY | Healthcare | 139,590 | 66.51 | 1.60 | 8 | 12% | 18% | 2.53 | 11.07 | -17.2% |
| 26 | Broadcom* | US:AVGO | Technology | 259,543 | 622.52 | 1.33 | 15 | 7% | 30% | 0.78 | 13.22 | 13.0% |
| 27 | Mosaic* | US:MOS | Non-Energy Materials | 17,679 | 52.54 | 0.47 | 8 | 12% | 18% | 0.24 | 6.43 | 2.4% |
| 28 | DXC Technology | US:DXC | Technology | 6,009 | 26.39 | 1.81 | 7 | 15% | 16% | 0.66 | 5.20 | -11.1% |
| 29 | C.H. Robinson* | US:CHRW | Industrials | 12,041 | 103.35 | 1.58 | 22 | 6% | 45% | 21.98 | 7.70 | 3.1% |
| 30 | EOG Resources | US:EOG | Energy | 67,588 | 115.00 | - | 9 | 9% | 20% | 0.84 | 9.03 | -19.0% |
Source: FactSet, as of 10 Mar 2023. NTM = next 12 months. *Momentum stocks | ||||||||||||
