Here's Everything You Need to Know About Free Cash Flow Yield
The most underutilized valuation metric
At the end of the day, free cash flow matters the most.
But what is free cash flow, and how can I use it to figure out if a company is undervalued?
In this article, I’ll teach you exactly what you need to know about one of the most important metrics in finance.
The big picture proof
This graph shows the S&P 500 vs the Free cash flow yield (FCF yield) of the S&P 500.
Notice how every time the green line (FCF Yield) diverges from the S&P 500, the S&P 500 starts to appreciate.
Credit to Banyan Hill for the graph
What is free cash flow?
The official formula for free cash flow (FCF) is:
Free cash flow = Operating cash flow - CAPEX
Or (broken down version)
Free cash flow = Net income + Non-cash Expenses - Increase in Working Capital - Capital Expenditure
It’s simply the cash that enters a company minus the cash that leaves a company.
Operating cash flow is the amount of cash generated by a company’s normal business operations. I.e. all the cash generated from selling products / services.
And CAPEX is how much money a company used to maintain or buy physical assets.
The higher the free cash flow, the better. Simple. Cash is king.
Why is Free Cash Flow Yield so Important?
The free cash flow yield (FCF Yield) is one of the best valuation metrics of a company.
The FCF Yield provides a true insight into the financial health and profitability of a company.
Companies that have the ability to generate consistent cash tend to have a long-term competitive advantage and are therefore better positioned to weather economic downturns and strive in growth periods.
But why is FCF Yield better than other financial ratios?
The most well-known “valuation metric” is P/E ratio.
This focuses on the earnings of a company which does not reflect the actual cash flow, and therefore may not give a true insight into a company’s ability to generate cash.
Alternatively, you have Return on Equity (ROE), which is a measure of profitability based on equity. This does not take into account any cash flow meaning a company may have a strong ROE, but is not able to generate cash.
How to Calculate Free Cash Flow Yield?
Here’s the formula:
Free cash flow yield = Free cash flow / Market cap
Or
Free cash flow yield = Free cash flow per share / stock price
The higher the ratio, the better value the stock as the business is generating more cash per-share.
But higher compared to what?
You can compare to the company’s historical average (5 year average)
You can compare to competitors
Example:
Let’s take a look at 2 pharmaceutical giants, Johnson & Johnson and Pfizer.
Johnson & Johnson
Johnson & Johnson has free cash flow of $17,185M.
With a market cap of $381.26B, this leads to a FCF Yield of:
FCF Yield = $17,185M / $381.26B
= 4.5%
P.s I use Stratosphere to get these figures. If you want to see a detailed breakdown of the actual calculations, then I’d be more than happy to show you this in another article. I believe if you want to screen many stocks, there’s no point doing the calculations yourself if the information is already out there.
Pfizer
Pfizer has free cash flow of $2,907M.
With a market cap of $187.63B, this leads to a FCF Yield of:
FCF Yield = $2,907M / $187.63B
= 1.5%
Therefore, in terms of FCF Yield Johnson & Johnson is a much better investment currently.
Despite this, the P/E Ratio of Johnson & Johnson is slightly higher at 29.66 compared to 25.78 at Pfizer.
Therefore, if you didn’t look at FCF Yield you may think that Pfizer was a better investment since the price of the stock was cheaper.
This is why it is important to look at multiple metrics.
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That’s it for the day
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About the author
Make Money, Make Time is written by Oliver, a qualified CA, and investor who has read over 300 investment books, and spend more than 50 hours per week researching stocks so that you don’t have to.