A FCF/EV Screen - Finding A Winning Horse

9th Mar '23 by Mark Simpson

4 comments 4364 reads

When I wrote about Price-to-Sales, I called it the King of Value Factors quoting Jim O'Shaughnessy, who found that this was the best-performing Value factor for US stocks from 1951-2003. What was notable was how badly the decile with the highest Price-to-Sales did. This generated just a 3% compound return, less than inflation for the period:

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One thing is clear from this long-term study: investors really don't want to be in the highest Price-to-Sales stocks. However, 2003 is a long time ago and reflects a general market nadir, which may have undue influence on the results. When Gray and Carlisle did their pretty exhaustive study into which value factor performed the best, using 1971-2011 data, Price to Sales didn't even make the running.

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Reader @iwright7 pointed out in the comments that there have been some more recent studies than this. For example, in 2014, Jim O'Shaughnessy’s son Patrick suggested screening for EV/FCF <10 as a good Value metric. He also quoted the following research called An Update on the Valuation Metric Horserace: 2011-2015, also by Wes Gray, with Jack Vogel, which concluded:

B/M REALLY stunk.
Enterprise multiples stunk (although variations such as EBIT/TEV were a bit better).
E/M (which represents P/E) were lame.
Gross profits / TEV results were pretty solid.
FCF/EV was great!

So we now have data as recent as 2015, which suggests we should be looking at EV/FCF. And I agree FCF is an excellent value metric. At the end of the day, a business is worth the net present value of the cash it returns to shareholders over its life. Producing large amounts of cash flow now, which could be returned to shareholders if appropriate, is a good sign.

It is tempting to think that we could build a very simple screen taking the lowest decile on EV/FCF (we want companies with the highest FCF), exclude the very smallest companies and invest in the whole set to generate market-beating returns. Something like this:

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However, we must be careful about throwing away all the other Value metrics. The results that Gray & Vogel are referring to are for the five years from 2011-2015. When they look at the full sample from…

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simoan

9th Mar '23

Mark,

Interesting article. Must admit I've never used EV/FCF as a valuation measure before.

However, it highlights one of my bugbears with regard to screening on Stockopedia i.e. the FCF screening options are limited to TTM only! Screening for trailing twelve months is all very well but one year's impressive FCF does not really tell you very much, or indicate whether company is an undervalued cash generating machine, or not. FCF varies so much from year to year (generally much more than EPS) that what is really needed is an indication that FCF has been good over a number of years in the same way that there are multi-year averages for metrics such as ROE, ROCE and OM. Currently, this is a manual check I have to perform rather than use FCF TTM as part of a screen, which I find too limiting.

All the best, Si

1PHARAUN1

Great content. Thanks for sharing

iwright7

Thanks for the "hat tip" in your excellent review. I know you are a Value investor, though I like to mix up investing styles and particularly like high Quality/Momentum (QM) type stocks . Your screen (with a couple of adjustments) allows for this too.

I upped the min Mrk Cap to £25M to exclude the minnows and ordered your EV/FCF screen output by QM Rank. This produces the following results:

We now get 15 high QM stocks and because your EV/FCF criteria has screened out expensive junk, these 15 turn out to be high VM to; far right column). On paper we have the best of the Value, (with added Quality and Momentum) worlds, which are suitable for further research.

Disclosure - I use a similar EV/FCF screening method and hold 5 of these 15 stocks. I do particularly like £Jet2.

10th Mar '23

A further comment in relation to EV/FCF to add that I like your additional EV/EDITDA >70% market, screening rule. This is because as good as EV/FCF is there is a danger when a single Value metric is used to choose stocks, that the screen is going to select stocks whose fundamentals happen to be exaggerated for that particular metric.

The market may spot this exaggerated aspect and price correctly, but with less company research and institutional restrictions in small caps I do believe that small caps offer the best chance of outperforming, even when a single value metric is used.

Instead of placing our bets on a single metric, we can also use an array of well-tested factors e.g. such as the Stocko Value composite (+ Quality and Momentum composites) to mitigate an abnormal metric. The different factors will cover each other’s blind spots, helping to improve the chance of winning.

A FCF/EV screen - finding a winning horse

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Mark Simpson

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