Free Cash Flow Yield

What can free cash flow yield offer the individual investor?

Key Metrics: Free Cash Flow Yield

First up in the Key Metric series we have Free Cash Flow (FCF) Yield

Every investor should have a repertoire of fundamentals they analyze. The greatest investors throughout history all performed extensive fundamental analysis on each of their investments. These indicators include P/E, PEG, P/S, and many others, but one you might not think about immediately is FCF Yield.

“Free cash flow generation is the foundation from which we can deliver sustainable shareholder returns throughout the cycle.” — Sam Walsh

Peter Lynch, Warren Buffett, Ken Fisher, and several other successful investors loved to use FCF metrics when analyzing companies, and for good reason. Free cash flow is harder to manipulate than earnings and is the core engine behind dividends, buybacks, and company reinvestment. FCF metrics are very important to have in your checklist, so keep reading to learn more about FCF Yield.

What is FCF Yield?

Cash in the bank is what every company, and investor, strives for. Companies with large amounts of cash have options to increase dividends, perform buybacks, or reinvest the capital back into their business. Cash flow is the amount of cash coming in minus the amount of cash going out of the company's bank. Free cash flow is the amount remaining after business expenses and capital expenditures have been paid. Capital expenditures can be defined as expenses to improve the business, reinvestment, and day to day business operating costs. You can calculate the FCF yield fairly quickly, but first you must understand what is in the equation and what the variables mean. I should mention by the way, the YourPortfolio Software has the FCF yield already calculated for you.

The equation is simply:

Free Cash Flow / Market Cap = FCF Yield
But let's break that down even more. How do we calculate free cash flow? First, look at the cash flow statement. Next, find the total amount from cash generated from operations. Lastly, take the amount from the capital expenditures (CAPEX) line, it will be in the investing section, and subtract it from the cash generated from operations. For example, if Company A has made $1,000 from operations and only spent $500 on capital expenditures, its free cash flow would be $500.

Market capitalization is simply the product of shares outstanding and the share price. So let's go back to Company A for an example. Let's say they have 1,000 shares outstanding selling for $20/share. The market cap for Company A would be $20,000. In order to find the free cash flow yield, all we have to do is take the free cash flow number ($500) and divide it by the market cap ($20,000), giving us 0.05, or 5%.

$500 / $20,000 = 0.05, or 5%

What Does FCF Yield Reveal?

Now that we're done with the boring part, it's time to see what FCF yield can inform us about a company. I mean, there has to be some reason why the great investors often analyzed free cash flow metrics isn't there? The short answer is yes, indeed. One of the beauties about cash flow, especially free cash flow, is its much harder to manipulate than net earnings. With cash, you either have it or you don't. Remember, with this metric we are looking at operating earnings. By doing this, it removes potential discrepancies from one-time gains, losses, or manipulation that can be seen with net earnings. Free cash flow is much less susceptible to accounting gimmicks than net earnings as well.

You can also use FCF yield as another way to value a company, similar to the way many value investors use earnings yield. For instance, Company A had a FCF yield of 5%. That's not terrible, but if we could find a company with a FCF yield of 15% I would be very excited. Compare that to the 2.5%, 10-year treasury bond rate right now and you would potentially have a much better investment opportunity.

How to Use FCF Yield

Obviously, you want to see a positive free cash flow and the higher the FCF yield the better. But you still must analyze further to determine if you should invest or not. As I stated in the first blog of this series, there is simply no one metric that should ever determine if you invest or not. Personally, if I see a company with a FCF yield of 10% or greater, I will definitely analyze further.

What about results? In Quantitative Value Investing in Europe: What works for achieving alpha, a research paper by Phillip Vanstraceele, we see FCF yield does pretty well. The chart below compares companies with the highest FCF yield vs companies with the lowest FCF yield during the period 1999-2011.

Trailing 12-Month FCF Yield
Market Cap Q1 Q2 Q3 Q4 Q5
Small Cap (>15m and <100m) 186% 69.5% 1.8% -18.3% -51.8%
Mid Cap (>100m and <1000m) 317.4% 107.9% 16.1% -14.1% -6.3%
Large Cap (>1000m) 242.8% 147.7% 59.8% -1.8% 30.7%

5-Year Average FCF Yield
Market Cap Q1 Q2 Q3 Q4 Q5
Small Cap (>15m and <100m) 113% 109.4% -27.7% 12.5% -49.2%
Mid Cap (>100m and <1000m) 325.8% 138.4% 4.2% -24.1% -6.8%
Large Cap (>1000m) 171.2% 148.5% 108.2% 3.5% 12.7%
Q1 represents the 20% highest FCF Yield companies while Q5 the worst 20% FCF Yield companies

As you can see, companies with higher FCF Yields tend to perform much better. However, as with all metrics, FCF yield does have its limitations. For instance, a company may have a deceivingly high FCF number because they are not reinvesting, or maybe they are putting off other necessary capital expenditures. Similarly, FCF could be falsely low because they may have invested heavily in a much needed area, increasing CAPEX and reducing FCF.

One other limitation I want to discuss is debt. When companies use a significant amount of debt to finance their operations, FCF yield often looks deceptively high. This is why many value investors prefer to use enterprise value (EV) rather than market cap in the FCF yield equation. EV takes the amount of debt into account and can offer a more realistic valuation than market cap. So a fancier, more sophisticated equation would look like this:

FCF / EV = FCF Yield
 If you prefer using market cap that's fine, just remember this equation if you come across an astronomical FCF yield.