Introduction

The goal of any value investing strategy is to identify companies
that are trading at discounts to their intrinsic value, and to profit
off the difference. To do this, investors will look at a company’s
financial statements to find their financial metric of choice.

This financial metric is then converted to a valuation ratio to make it comparable to other stocks, which allows investors to determine which potential investment is most attractive. This article will look at different financial metrics used in the most common valuation ratios and explain why we believe free cash flow gives the best view of a company’s overall financial position.

What are the most commonly used financial metrics?

One of the most commonly used measures of a company’s financial position is book value. Book value is derived from a company’s balance sheet and is calculated simply as Total Assets – Total Liabilities. Book value strives to look at the totality of what a company owns vs what they owe. The rest of the metrics we will look at ask the question: how does a company use those assets and liabilities to make money?

Sales or revenue is another commonly used financial metric, it looks at how much money a company generates from selling their goods or services. It can found on the income statement. From sales, one can determine a company’s earnings by factoring in (subtracting) expenses. Earnings is also one of the most widely used financial metrics, but it is hypothetical and uses accounting assumptions such as depreciation. One can get a more accurate reflection of a business’ performance by measuring cash flow, which does not include as many assumptions and refers to the cash in hand, left over after paying the bills.

What is free cash flow and why do we believe it is superior?

Finally, free cash flow can be calculated by subtracting a company’s capital expenditures from their cash flow, giving the investor a holistic measure of the cash remaining after a company has reinvested in the business. The excess free cash flow can then be used to do a number of things, most notably: pay dividends, buy back stock, or participate in mergers and acquisitions. The chart below shows the most common financial metrics used by investors and how free cash flow is derived:

As you can see, the financial metrics listed above each build on the information from the ones before and merely serve as a guide to help determine a company’s free cash flow.