Unlocking Superior Stock Performance with Free Cash Flow

Free cash flow is a crucial valuation metric according to Warren Buffett. Intangible assets now make up over 80% of the S&P 500's total assets, making it more important to focus on free cash flow. A low price-to-book-based portfolio returned 519% between 2002 and 2024, while a free-cash-flow yield portfolio returned over 1100%. ETFs like COWZ, VFLO, and QOWZ invest in companies with strong cash flows and favorable growth prospects.

Free cash flow (FCF) has emerged as a crucial valuation metric, particularly in an era where intangible assets dominate corporate balance sheets. Warren Buffett, the legendary investor, has long advocated for the significance of FCF in identifying undervalued companies. According to Buffett, FCF is the most important metric for valuation because it reflects a company's ability to generate cash after covering expenses, interest, taxes, and long-term investments [1].

In the past four decades, the composition of company assets has shifted dramatically. Intangible assets, such as intellectual property, software, and brand value, now make up over 80% of the S&P 500's total assets. This shift has rendered traditional valuation metrics, such as the price-to-book value (P/B) ratio, less effective [1]. Focusing on FCF yields better results, as evidenced by the performance of low P/B-based portfolios versus those focused on FCF yield. Between January 2002 and June 2024, a low P/B-based portfolio returned 519%, while a portfolio focused on FCF yield returned over 1100% [1].

ETFs like COWZ, VFLO, and QOWZ capitalize on this trend by investing in companies with strong cash flows and favorable growth prospects. COWZ selects 100 US companies with robust cash flows and healthy balance sheets from the Russell 1000 index. VFLO holds profitable large-cap companies with high FCF yields and promising growth prospects. QOWZ invests in companies with continuous and stable growth in FCF [2].

Chevron (NYSE:CVX) is a notable example of a company that has successfully leveraged FCF to drive its valuation. The company's operations in the Permian Basin are expected to generate $5 billion in annual cash flow by 2027, according to Bruce Niemeyer, president of Chevron's shale business. By reducing capital spending without cutting production, Chevron aims to grow its FCF from the Permian by $2 billion over the next two years, reaching $5 billion annually by 2027 [3].

In conclusion, the importance of free cash flow in valuation cannot be overstated, especially in an era dominated by intangible assets. Investors and financial professionals should focus on FCF to identify undervalued companies and make informed investment decisions. ETFs like COWZ, VFLO, and QOWZ offer a convenient way to invest in companies with strong cash flows, providing a solid foundation for long-term growth.

References:
[1] https://www.ainvest.com/news/contrarian-edge-buffett-picks-defy-momentum-stocks-nvidia-2507/
[2] https://finance.yahoo.com/news/why-free-cash-flow-drives-164200231.html
[3] https://seekingalpha.com/news/4468525-chevron-believes-permian-can-produce-5b-in-annual-free-cash-flow-by-2027---bloomberg