The best companies to buy are ones that have large and growing amounts of free cash flow.
One possible drawback of this approach: you will ignore companies with small or even negative free cash flows because they are investing heavily in new assets to grow their future sales, profits and operating cash flows.
Should you ignore companies like this?
Ideally, you will try to find companies that don't need to spend a lot of capex to grow.
However, if you come across what appears to be a quality company that is spending a lot of money, then you need to make sure the company is getting a good return on that investment.
You need to look at the trend in ROCE at the same time as you are looking at free cash flow.
If ROCE is high and rising whilst a company is spending heavily then the company could start generating lots of free cash flow when its spending settles down - if it ever does.
The main issue is how much money the company needs to spend to maintain its assets in a steady state.
The point here is that you might be making a mistake by ignoring companies with low or negative free cash flow.
There could be a great cash flow business waiting to blossom.
Four simple rules
Four simple rules when comparing FCF per share with EPS when looking for possible investment candidates:
1. FCFps is 80% or more of EPS = definite candidate
2. FCFps is less than 80% of EPS and ROCE is increasing = possible candidate
3. FCFps is less than 80% of EPS but ROCE is falling = avoid
4. FCFps is consistently negative = avoid
The free cash flow per share figure is all-revealing: you want to see quality companies with a consistently similar EPS and FCFps, not companies where these numbers are markedly different.
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