Given profit can be subject to alterations and adjustments and presented in a flattering light, trying to find value purely based on the ratio between a company’s share price and earnings per share can trip you up.

A solution is to look at firm’s cash flow instead. It is best practice to look at free cash flow which is the cash a company generates through its operations minus any capital expenditure.
This metric is transparent and companies which produce sustainably high free cash flow year after year are ones with quality characteristics.

Private equity firms often use the free cash flow yield, calculated by dividing free cash flow by the enterprise value of a business (its market valuation plus any net debt or minus any net cash), when assessing targets. They compare the free cash flow yield to the cost of borrowing to make acquisitions.

To help with idea generation, Shares has run a screen of the market using Stockopedia data to identify stocks which look cheap relative to cash flow. Doing homework on the full list we have picked three stocks worth buying.

SCREENING THE MARKET FOR CANDIDATES

First, we narrowed our search to businesses with market values above £100 million as below this threshold the liquidity of the shares can be an issue and the risks are typically higher. We also stripped out financials and property stocks because the complexity of their balance sheets and accounting can make like-for-like comparisons with other sectors less meaningful.

Next, we looked at firms with a ratio of enterprise value to free cash flow of less than 10 on a trailing 12-month basis – this is our core value metric. We also looked for names with a five-year average return on equity of 6% or more to ensure we are capturing reasonable quality businesses.

Finally, to ensure the amount of cash generated by our businesses is growing, we looked for a positive five-year compound annual growth rate in free cash flow.

This produced a list of 32 names. Housebuilders feature heavily but we are cautious on their immediate prospects for the sector as the housing market begins to show signs of stress. Resources firms also feature heavily but investors should consider the volatility in the underlying commodities from which they derive their
cash flow.

In the end we have arrived at a trio of different businesses, all of which generate good amounts of cash and look cheap relative to this cash flow. [TS]

Clarkson (CKN) £30.45

Shipbroking and shipping services firm Clarkson (CKN) may be over 150 years old, but it knows how to move with the times.

Its investments in technology and solutions mean its clients have been able to ride out the disruption to global trade caused by the pandemic and the invasion of Ukraine, generating record profits of a tick over £100 million for the firm in 2022.

On top of its highly successful broking business, the firm’s sale and purchase division had a good year due to the lack of new capacity coming to the market.

Clarkson is also ready for the future with its Green Transition consultancy, which advises clients on the most pressing issue facing the whole transport sector – how to drive down carbon emissions.

Analysts at Canaccord believe the firm’s technological edge means cash flow will grow faster than sales, supporting further increases in the dividend which has risen every year for the past two decades. [IC]

Hollywood Bowl (BOWL) 232.5p

Ten-pin bowling and mini-golf centre operator Hollywood Bowl (BOWL) has grown free cash flow by around 28% a year over the last five years, demonstrating its cash generating characteristics.

The company provides an affordable treat for families which means the business should remain resilient should the economy falter from rising interest rates.

Hollywood Bowl is more profitable than before the pandemic, generating EBITDA (earnings before interest, tax, depreciation and amortisation) for the financial year ending 30 September 2022 of £61 million against £38 million in the last pre-pandemic financial year.

Despite strong performance the shares remain valued below 2019 levels with a price to earnings ratio of 13.4 times compared with 14.4 times in 2019 based on forecasts for the 12 months to 30 September 2023.

This looks far too grudging given a plan to open 12 new centres across the UK out to September 2025 and the opportunity to consolidate the Canadian market which the company entered in May 2022. [MG]

Shoe Zone (SHOE:AIM) 240p

Value footwear retailer Shoe Zone’s (SHOE:AIM) incredibly cash-generative business model has delivered a five-year free cash flow compound annual growth rate of 33% according to Stockopedia.

A discounter in the relatively non-discretionary footwear category, Shoe Zone does an exceptional job of managing its direct-from-factory supply chain and keeps a tight lid on costs across the business. This includes reducing its rent bill through proactive discussions with landlords with an average lease length of just 1.8 years giving the retailer the flexibility to respond to changes in any retail location at short notice.

Debt free once again and back on the dividend list after a pandemic-induced hiatus, Shoe Zone is returning capital to shareholders through ordinary and special dividends as well as a share buyback programme that started in August 2022.

Prospects look solid with Shoe Zone profiting from the cost-of-living crisis as families on a budget trade down to cheap shoes, boots, trainers and slippers. The company is also benefiting from the post-pandemic return to physical stores, store refits and investments to improve digital efficiency. [JC]

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