Unlock deeper insights into Initial Public Offering (IPO) performance. This research-backed article, co-authored with Mr. Ted Theodore and originally featured in Financial Advisor Magazine, explores a critical fundamental indicator: free cash flow. Moving beyond market hype, discover how a company’s free cash flow generation and its underlying trend can significantly predict stock returns in the crucial post-IPO period. This analysis provides a data-driven approach for investors considering newly listed companies.
With the recent wave of initial public offerings, including prominent names like Lyft, Pinterest, and Uber, many investors are naturally pondering the advisability of investment. A pervasive concern surrounding a company’s public debut often centers on its projected path to profitability. This outlook can frequently appear ambiguous, influenced by factors such as nascent liquidity, inherent market volatility, and other elements seemingly disconnected from the issuer’s core operating performance. Instead of relying on speculation, a more systematic framework for evaluating IPOs may offer a superior approach.
Our proprietary research suggests that free cash flow (FCF) serves as a robust indicator for predicting stock returns, not only across global equity markets but also specifically for newly listed companies in the post-IPO phase. But what precisely constitutes “free cash flow” in this context? Simply defined, FCF represents the cash a company generates from its core operating activities, after accounting for the capital expenditures necessary to maintain its fixed assets.
Free cash flow stands as a critical analytical consideration because it circumvents many of the discretionary elements inherent in Generally Accepted Accounting Principles (GAAP). Its direct focus on cash generation offers a less manipulable view of a company’s underlying financial health.
Research Methodology
Given the recent surge in IPO activity, our study focused on all IPOs with a market capitalization exceeding US$1 billion that debuted between May 1995 and March 2019. For assessing stock return, we utilized the month-end date following an IPO as the starting point, then analyzed the subsequent one-, three-, six-, and twelve-month total returns.
Free Cash Flow Generation vs. Post-IPO Performance
Initially, we investigated the direct relationship between post-IPO stock return and a company’s free cash flow generation. Free cash flow generation was defined as the annual free cash flow reported in the company’s latest fiscal year filing prior to the IPO. Our findings indicate a clear performance divergence: the average performance of IPOs with positive free cash flow generation consistently outperformed those without by notable margins across various time horizons:
- 1.08% in the next one-month period
- 3.37% in the next three-month period
- 10.07% in the next six-month period
- 15.67% in the next twelve-month period
Impact of Free Cash Flow Trend
Next, we examined whether the trend of free cash flow held predictive power for post-IPO returns. We defined free cash flow trend as the general direction (positive or negative) in which a company’s free cash flow was developing or changing leading up to the IPO. The results mirrored our initial findings, with IPOs exhibiting a positive free cash flow trend outperforming those without by identical margins:
- 1.08% in the next one-month period
- 3.37% in the next three-month period
- 10.07% in the next six-month period
- 15.67% in the next twelve-month period
Combined Free Cash Flow Metrics
To gain a more holistic perspective, we integrated both free cash flow generation and free cash flow trend. The combined analysis yielded even more compelling results:
We observed that companies demonstrating both positive free cash flow generation and a positive free cash flow trend outperformed companies with both negative free cash flow generation and a negative free cash flow trend by an average of 24%. This spread is notably higher than the average 16% spread observed in next twelve-month returns when using a single free cash flow measure.
Furthermore, our analysis revealed that companies with positive free cash flow generation but a negative free cash flow trend produced a moderate return of 6.59% on average (or 7.35% in median) over the subsequent twelve months. This performance was superior to companies exhibiting negative free cash flow generation coupled with a positive free cash flow trend, highlighting the sustained importance of current FCF generation.
Case Studies: Largest IPOs (1995-2019)
Investors contemplating an IPO often gravitate towards popular names, sometimes at the expense of diligent fundamental analysis. Our evidence, however, strongly suggests that fundamental factors continue to provide meaningful insight into prospective stock performance, even for companies newly entering the public markets.
Examining the IPOs of the 30 largest companies by current market capitalization from May 1995 through March 2019, clear patterns correlating performance outcomes with free cash flow generation and trend emerge. For instance, the five stocks in this cohort with the highest 12-month post-IPO return (Mastercard, Google, Synchrony Financial, Chicago Mercantile Exchange Holdings, and ServiceNow) consistently exhibited positive free cash flow generation and a positive free cash flow trend. Conversely, among the five worst-performing stocks on this list over their initial 12 months (GM, Alibaba, MetroPCS, Philip Morris, and HCA Healthcare), only one, Alibaba, displayed positive free cash flow generation and trend.
Conclusion
As recent market activity underscores, a bold-faced name or significant public profile does not inherently guarantee outperformance in the public markets. We contend that free cash flow, assessed in terms of both its current generation and the discernible trends it highlights, offers a potentially effective methodology for making educated and informed decisions regarding IPO investments. This approach helps to cut through speculative hype, providing a clearer indication of how a company and its stock may perform over time, particularly relative to newly public peers.