Free Cash Flow Yield: The Best Fundamental Indicator

When evaluating stocks, most investors are familiar with fundamental indicators such as the price-to-earnings ratio (P/E), book value, price-to-book (P/B), and the PEG ratio. Also, investors who recognize the importance of cash generation use the company's cash flow statements when analyzing its fundamentals. They acknowledge that these statements offer a better representation of the company's operations.

However, very few people look at how much free cash flow (FCF) is available vis-à-vis the value of the company. Called the free cash flow yield, it's a better indicator than the P/E ratio.

Free Cash Flow


Cash flow is the measure of money into and out of a company's bank accounts. Free cash flow, a subset of cash flow, is the amount of cash left over after the company has paid all its expenses and capital expenditures (funds reinvested into the company).

You can quickly calculate the free cash flow of a company from the cash flow statement. Start with the total from the cash generated from operations. Next, find the amount for capital expenditures in the "cash flow from investing" section. Then subtract the capital expenditures number from the total cash generated from operations to derive free cash flow (FCF).

When free cash flow is positive, it indicates the company is generating more cash than is used to run the business and reinvest to grow the business. It’s fully capable of supporting itself, and there is plenty of potential for further growth. A negative free cash flow number indicates the company is not able to generate sufficient cash to support the business. However, many small businesses do not have positive free cash flow as they are investing heavily to grow their venture rapidly.

Free cash flow is similar to earnings for a company without the more arbitrary adjustments made in the income statement. As a result, you can use free cash flow to help measure the performance of a company in a similar way to looking at the net income line. (Free cash flow is not the same as net cash flow, however.)

Free cash flow is the amount of cash that is available for stockholders after the extraction of all expenses from the total revenue. The net cash flow is the amount of profit the company has with the costs that it pays currently, excluding long-term debts or bills. A company that has a positive net cash flow is meeting operating expenses at the current time, but not long-term costs, so it is not always an accurate measurement of the company’s progress or success.

The P/E ratio measures how much annual net income is available per common share. However, the cash flow statement is a better measure of the performance of a company than the income statement.


Free Cash Flow Yield: A Fundamental Indicator

Free Cash Flow Yield



Free Cash Flow Yield = Free Cash Flow Market Capitalization \text{Free Cash Flow Yield} = \frac{\text{Free Cash Flow}}{\text{Market Capitalization}} Free Cash Flow Yield=Market CapitalizationFree Cash Flow

Market Capitalization

Another way to calculate free cash flow yield is to use enterprise value as the divisor. To many, enterprise value is a more accurate measure of the value of a firm, as it includes the debt, value of preferred shares, and minority interest, but minus cash and cash equivalents. The formula is as follows:

Free Cash Flow Yield = Free Cash Flow Enterprise Value \text{Free Cash Flow Yield} = \frac{\text{Free Cash Flow}}{\text{Enterprise Value}} Free Cash Flow Yield=Enterprise ValueFree Cash Flow

Enterprise Value



Using Free Cash Flow Yield

As an example, the table below shows the free cash flow yield for four large-cap companies and their P/E ratios in the middle of 2009. Apple (AAPL) sported a high trailing P/E ratio, thanks to the company's high growth expectations. General Electric (GE) had a trailing P/E ratio that reflected a slower growth scenario. Comparing Apple's and GE's free cash flow yield using market capitalization indicated that GE offered more attractive potential at this time.

The primary reason for this difference was the large amount of debt that GE carried on its books, primarily from its financial unit. Apple was essentially debt-free. When you substituted market capitalization with the enterprise value as the divisor, Apple became a better choice.

Comparing the four companies listed below indicates that Cisco was positioned to perform well with the highest free cash flow yield, based on enterprise value. Lastly, Fluor had relatively a low P/E ratio that could be indicative of a value buy. But this thesis doesn't seem feasible when taking its relatively low FCF yield into account.

Image by Sabrina Jiang © Investopedia 2020

Liability Adjusted Cash Flow Yield

Although not commonly used in company valuation, liability-adjusted cash flow yield (LACFY) is a variation. This fundamental analysis calculation compares a company's long-term free cash flow to its outstanding liabilities over the same period. Liability-adjusted cash flow yield can be used to determine how long it will take for a buyout to become profitable or how a company is valued. The calculation is as follows:

Average Free Cash Flow

10 Y A F C F [ ( O S + O + W ) × P S P L ] ( C A I ) where: 10 Y A F C F = 10 -Year average free cash flow O S = Outstanding shares O = Options W = Warrants P S P = Per share price L = Liabilities C A = Current assets I = Inventory \begin{aligned} &\frac{10YAFCF}{[(OS+O+W) \times PSP-L]-(CA-I)}\\ &\textbf{where:}\\ &10YAFCF = 10\text{-Year average free cash flow}\\ &OS = \text{Outstanding shares}\\ &O = \text{Options}\\ &W = \text{Warrants}\\ &PSP = \text{Per share price}\\ &L = \text{Liabilities}\\ &CA = \text{Current assets}\\ &I = \text{Inventory} \end{aligned} [(OS+O+W)×PSPL](CAI)10YAFCFwhere:10YAFCF=10-Year average free cash flowOS=Outstanding sharesO=OptionsW=WarrantsPSP=Per share priceL=LiabilitiesCA=Current assetsI=Inventory

To see whether an investment is worthwhile, an analyst may look at 10 years' worth of data in a LACFY calculation and compare that to the yield on a 10-year Treasury note. The smaller the difference between LACFY and the Treasury yield, the less desirable an investment is.

The Bottom Line

Free cash flow yield offers investors or stockholders a better measure of a company's fundamental performance than the widely used P/E ratio. Investors who wish to employ the best fundamental indicator should add free cash flow yield to their repertoire of financial measures.

You should not depend on just one measure, of course. However, the free cash flow amount is one of the most accurate ways to gauge a company's financial condition.

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