With earnings season set to kick off this week – and analysts being bearish in their forecasts – now may be a good time to consider that quarterly reports may not always properly represent a company’s profitability. So, when it comes to equity valuation, free cash flow may provide a clearer picture of a firm’s prospects.
Free cash flow is the cash left over after a company has paid expenses, interest, taxes, and long-term investments. It is used to buy back stocks, pay dividends, or participate in mergers and acquisitions. And according to Bob Shea, CEO & CIO of FCF Advisors, a “more reliable” metric than earnings to evaluate a company’s financial health.
“GAAP earnings have significant disadvantages. Accounting practices allow a lot of leeway and discretion to management. They’re historically backward-looking,” Shea said. “But the ability to manipulate and distort free cash flow is much more difficult than [through]earnings.”
Shea added that FCF Advisors “has always focused on the lens of cash statements rather than GAAP earnings. It’s just a better representation of a company’s strength.”
FCF Advisors specializes in free cash flow investment strategies, primarily through its Free Cash Flow Quality Model. They have been focused on free cash flow factors since 2011 and are specialized in multi-factor fundamental analysis grounded in decades of research.
Two exchange traded funds that FCF Advisors offers that specialize in free cash flow are the FCF US Quality ETF (TTAC) and the FCF International Quality ETF (TTAI).
TTAC aims to outperform the Russell 3000 through a fundamentals-driven investment process that selects an average of 144 stocks based on free cash flow strength. Its holdings are then weighted by a modified market-cap log transformation, allowing increased exposure to companies with the strongest proprietary free cash flow rankings.
TTAI, meanwhile, aims to outperform the MSCI All Country World Index ex the U.S. through an active investment process. A quant model is used to rank stocks based on proprietary measures of free cash flow. Roughly 140 of the highest-ranked stocks are selected and then weighted on a modified market-cap basis that factors in free cash flow and log transformation.
Both ETF portfolios will also be rated with an ESG score, excluding companies with low ESG ratings. Firms with an extreme rise in shares count and increase in leverage are excluded.
For more news, information, and strategy, visit the Free Cash Flow Channel.