Free Cash Flow To Sales Ratio
To calculate the Free Cash Flow To Sales ratio, simply divide a company’s annual free cash flow by its annual sales.
The Free Cash Flow To Sales Ratio is a profitability measure which describes how much of a company’s sales are turned into free cash flow within a reporting period.
A company’s ultimate value is the sum of its free cash flows created over time, discounted back to today (see DCF). Therefore, in general, the higher the percentage of free cash flow compared to sales, the better.
For example, in 2021, Microsoft (MSFT) reported free cash flow of $56.12 billion on sales of $168.09 billion. This resulted in an impressive Free Cash Flow To Sales Ratio of 33%.
However, there are exceptions, which I will discuss below.
What is a Good Free Cash Flow To Sales Ratio?
Pat Dorsey from Morningstar suggests that a Free Cash Flow To Sales Ratio of above 5% is a good sign that a company is able to convert a significant portion of its sales into cash, which often indicates that a company benefits from an economic moat.
Suppressed Free Cash Flow To Sales
However, there are companies that don’t make the 5% hurdle, yet have a strong economic moat. Instead of returning excess cash to shareholders, these companies reinvest their cash into growth and expansion, which in turn results in reduced cash flow in the short-term due to increased capital expenditures. The idea behind this strategy is that these investments pay off over the long-term to generate excess free cash flows down the road.
A great example is Costco (COST). Costco’s annual free cash flow to sales ratios between 2012 and 2021 ranged from only 0.5% to 3.3%. Yet, Costco has a wide moat, which Nick Sleep termed scale-economies shared in his Nomad Partnership Investment Letters. Instead of keeping large amounts of free cash flows to themselves, Costco’s strategy is to let their customers benefit from low prices, thereby retaining customers and gaining new ones.
Amazon’s (AMZN) free cash flow to sales ratios between ranged from 0.6% to 4.4% between 2011 and 2014, and only reached a ratio above 5% in 2015, with a maximum of 9.2% in 2019. Similarly, Amazon followed a similar scale-economies shared strategy, where customers benefit from low prices and other benefits such as one-day shipping due to its infrastructure and vast network of fulfillment centers.
Free cash flow-to-sales is a useful metric to analyze a company’s profitability, and is a complementary tool to other ratios such as return on equity (ROE), return on assets (ROA), and return on invested capital (ROIC).
By itself, it doesn’t tell the whole story about a company, as pointed out with the example of Costco and Amazon.
Therefore, it is necessary to look at other metrics and also read a company’s and competitors’ annual reports to identify the capital allocation strategies used by management, and to see whether these line up with the profitability metrics.
- The Five Rules for Successful Stock Investing – Pat Dorsey
- Nomad Partnership Investment Letters – Nick Sleep