Free cash flow per share and the price-to-FCF ratio provide a framework to decipherwhat&rsquo s happening in our stock portfolio.

If stocks are cheap today, why do they keep falling? 

The S& P 500 hit a high of 4,818 points at the start of this year and has since sunk by almost 25 per cent over the past 10 months. 

For investors who bought shares in 2021, there may be a tinge of regret at not selling at higher stock prices. 

But here we are. 

There may be many reasons why you want to sell. 

But behind all these questions is a deep, unsaid fear when it comes to selling your stocks.

WHAT IF you sell, and the stock goes up? 

WHAT IF you don&rsquo t sell, and the stock goes down? 

To solve this conundrum, we need to have a better understanding of what drives share prices. 

The two main drivers of share price

In my book, there are two main components that can cause the share price to increase or decrease: the free cash flow per share (FCF per share) and the price to FCF (P/FCF) ratio. 

Multiply these two factors, and you get the share price. 

This simple equation implies that the movement of both the FCF per share or the P/FCF ratio will have a direct impact on a company&rsquo s share price. 

But that is where the similarities between the two factors end.

Factor #1: The FCF per share

Let&rsquo s start with the first: the FCF per share.

FCF is calculated by taking the company&rsquo s operating cash flow minus its capital expenditure.

If we divide its trailing 12-months (TTM) FCF by the total number of shares on issue, you get the company&rsquo s FCF per share.   

More importantly, the FCF per share is a figure that is within a company&rsquo s control.

If the management team does a good job, they will bring in revenue, keep costs and capital expenditure in check &mdash then, the business will generate both operating and free cash flow, as a result.   

Under a scenario where the FCF per share goes up while the P/FCF remains the same, the share price will increase by the same amount as the FCF per share. 

The primary driver in this case is the FCF per share, a proxy for the management&rsquo s effort.     

Factor #2: The P/FCF ratio

The P/FCF ratio, on the other hand, is a figure driven by the prevailing stock market sentiment. 

Therefore, this ratio is not within the management&rsquo s control.   

If the stock market is feeling optimistic, a higher ratio is rewarded to its shares. 

Conversely, if sentiment turns sour, the stock market will bid down the ratio. 

As such, under the scenario where the P/FCF goes down while the FCF per share remains the same, the share price will also decrease.   

Unlike the first scenario, though, any gains or losses driven by P/FCF movements are less reliable, as market sentiments can turn on a whim. 

Short-term stock price movements

The equation above provides us with a framework to decipher what is happening to shares that we own. 

In the short term, share price movements are usually influenced by the P/FCF ratio.   

Take  Apple  (NASDAQ: AAPL), the manufacturer of the popular iPhone. 

For the first nine months of its current fiscal year (9M&rsquo FY22), the Cupertino company saw its FCF rise to US$90.6 billion, up by over 19 per cent from around US$76 billion a year ago.

In terms of FCF per share, it has risen from US$4.53 per share in 9M&rsquo FY21 to US$5.57 per share in 9M&rsquo FY22.   

Yet, despite the growth in FCF per share, Apple shares have fallen by 23 per cent this year. 

Clearly, the disparity between the iPhone maker&rsquo s business performance (represented by its FCF per share) and its share price performance is down to a shrinking P/FCF ratio. 

There is a reason for this pessimism.

To say today&rsquo s stock market sentiment is sour would be an understatement. 

The optimism of economies and borders reopening has been overshadowed by the pessimism of rising inflation and higher interest rates. 

Should the market sentiment brighten, this ratio could head higher.

Yet, as we said earlier, hoping for a higher P/FCF ratio is akin to hoping that investors&rsquo mood changes for the better, which is an unreliable way to invest.   

We need something more reliable to drive stock price returns.

When the long view trumps the short view

To be sure, we are not making light of the current economic situation. 

Already, Apple is facing headwinds such as supply constraints, foreign currency translation losses due to a strong US dollar and the impact on its business in Russia.

As investors, however, we have to separate between what&rsquo s temporary and what&rsquo s permanent. 

Should we take these current challenges as permanent? 

I don&rsquo t think so. 

If history has taught us anything, it&rsquo s the business growth, represented by the FCF per share, that will be far more consequential compared to a change in market sentiment. 

Let me explain.   

When I bought shares of Apple in June 2010 at a split adjusted US$8.75 per share, the business had generated US$0.47 per share in FCF over its trailing 12 months. 

The stock sported a P/FCF ratio of 18.7, as shown in the enclosed table. 

	FCF per share (TTM)	P/FCF	Share price
June 2010	US$0.47	18.7	US$8.75
October 2022	US$6.62	21.2	US$140.09
Growth	14.1x	1.1x	16x

Fast forward to today, and shares have risen by 16 times to around US$140 per share.

What&rsquo s interesting is the wide disparity between the key drivers behind the stock price increase. 

Granted, my shares did benefit from an increase in the P/FCF ratio. 

However, the contribution of the ratio is a mere 13 per cent over the past 12 years.

The clear driver is Apple&rsquo s FCF per share that has ballooned from US$0.47 when I bought the shares to over US$6.60 today.

Given the vast difference in contribution to Apple&rsquo s share price increase, what would you focus on? 

The answer is obvious: the business, represented by Apple FCF per share. 

Get Smart: The path to sustainable stock gains 

Buying with the hope of instant returns is a fool&rsquo s errand. 

You&rsquo re essentially praying that the stock market will be so kind as to award your shares with a higher P/FCF multiple. 

Hope is not a strategy. 

On the other hand, building a business, as Apple has shown, takes time. 

The iPhone maker did not deliver a 14-time increase in its FCF per share overnight. Instead, it was created over time.   

Yes, patience is required. 

Yes, it is not easy amid rising interest rates and higher inflation. 

But if done right, the rewards can be breathtaking. 

And that&rsquo s worth waiting for. 

Note:  An earlier version of this article appeared in The Business Times.

Working out the intrinsic value of a stock will enable you to invest with confidence.

Some of us might be fortunate enough to get to see the annual Hindu fire walking festival this month. I remember watching a Theemithi ritual a few years ago and thinking to myself that it was downright unsafe. But a Hindu devotee explained to me that it is only dangerous if you do not know what you are doing.

The thermodynamics behind fire walking is well known. However, the science does not detract in any way from the spectacular feat, as fire walkers stride confidently over a four-metre pit of glowing embers in their bare feet. But the knowledgeable devotee was absolutely right. Fire walking is only dangerous if we do not know what we are doing.

Some people have likened the buying of shares in a volatile stock market with walking barefoot on a bed of hot ashes. But as legendary investor Jeremy Grantham once remarked: &ldquo Volatility is a symptom that people have no idea of the underlying value.&rdquo

Warren Buffett  said something similar about risk, which is generally seen as a proxy for volatility. He said: &ldquo Risk comes from not knowing what you are doing&rdquo .

For many people, a volatile market could be a time for worry and distress. After all, it can be heart breaking to watch the value of our investments take a hit.

Legends vs mortals

But as Peter Lynch once quipped: &ldquo A stock market decline is as routine as a January blizzard in Colorado. If you&rsquo re prepared, it can&rsquo t hurt you.&rdquo He went on to say: &ldquo A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.&rdquo

That is easy for Lynch to say. He is, after all, a seasoned investor. But what about us mere mortals? How do we go about differentiating between undervalued shares and rip-offs dressed up as bargains? Are we not like wannabe fire walkers, going to get badly burnt, if we pick up the wrong stocks in a volatile market?

That can, indeed, be a dilemma. But it is not one that is insurmountable, provided we understand that cheap rubbish is still rubbish.

Walking on fire

The day I became a better investor &ndash or as I prefer to call it, the day I learnt to walk on fire &ndash was the day I understood the concept of intrinsic value. We need to understand that every company on the stock market has an intrinsic value.

The value could be derived from the stream of dividends that income investors enjoy by holding a stock. For value investors, it could be the sum of a company&rsquo s assets. For growth investors, it could be the earnings that owners of a share could reap over the long term.

The trouble is, if you don&rsquo t know the intrinsic value, then that could be tantamount to &ldquo playing poker without looking at the cards&rdquo , as Lynch once joked. But by recognising the concept of intrinsic value, we should be able to appreciate when shares have been unfairly punished.

That is the underlying message behind Warren Buffett&rsquo s sage advice: &ldquo Be greedy when the market is fearful, and be fearful when the market is greedy.&rdquo He did not say buy any old rubbish and just hope for the best. Buffett also said: &ldquo Look at market fluctuations as your friend rather than your enemy profit from folly rather than participate in it.&rdquo

Volatile times

The market at the moment is highly volatile. Given the US Fed&rsquo s quantitative tightening policy, war between Russia and Ukraine, China&rsquo s zero-Covid strategy, investors are understandably perplexed. But it is important to remind ourselves that if a business does well, then the stock eventually follows. In the short term, there is no correlation between a company&rsquo s success and its stock. But in the long term, there is a 100 per cent correlation.

So, try to focus on the long term and the 100 per cent correlation, rather than what might happen from day to day. And do not, like some, be tempted to ditch our best stocks for cash at the first sign of disaster. We are going through an economic slowdown. We are not going off to hell in a handcart.

In our special FREE report,  Top 9 Dividend Stocks for 2022  &ndash   and 3 Tactical Shifts to Maximise Your Profits, we&rsquo re revealing 3 special categories of stocks that are poised to deliver maximum growth in 2022 and beyond. 

Our  safe-harbour stocks  are a set of blue-chip companies that have been able to hold their own and deliver steady dividends.  Growth accelerators stocks  are enterprising businesses poised to continue their growth.  And finally, the  pandemic surprises  are the unexpected winners of the pandemic. 

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