Learn to Invest - Free Cash Flow Yield

Learn to Invest - Free Cash Flow Yield

Free cash flow yield is one of the best indicators used by fundamental analysts to select and assess companies. The higher the number the more free cash per share is being generated by the company. Companies can use their excess cash can to pay higher dividends, buy back shares, and re-invest in the company, all activities that lead to higher share prices.
Calculating Free Cash Flow Yield

For investors, cash in the bank is king. It is hard to hide financial misdeeds or problems in a company’s bank accounts. These bank balances show the truth in the financial performance of a company. This is why investors like to look at cash flow and free cash flow.

To calculate free cash flow yield, start with the Company’s Cash Flow Statement. On the cash flow statement, find the Cash Flow from Operations line. Then subtract capital expenditures to derive free cash flow. Free Cash flow is the money that is left over in the company’s bank accounts after paying the company’s bills and investing in new capital projects and equipment to help the company grow. It is best to use the annual cash flow numbers, so you have a more complete picture of the company’s financial situation.

Here is the formula: Cash Flow from Operations – Capital Expenditures = Free Cash Flow.

The standard way to calculate free cash flow yield is to use market capitalization, or total common shares outstanding times the share price. To find the free cash flow yield percentage divide free cash flow by market capitalization. This number is a calculated ratio indicating how much free cash flow is available per common share. Market Capitalization is readily available on the financial site such as Yahoo!Finance.

Some analysts believe there is a better measure to use than market capitalization. They prefer to use enterprise value, as it accounts for debt, value of preferred shares, minority interest, and cash. Enterprise value differs significantly from simple market capitalization since it is a more accurate representation of a firm's value. For example, if there company were to be acquired, the value of a firm's debt would need to be paid by the buyer. This makes enterprise value a more accurate valuation measure.

Using enterprise value as the divisor adjusts the free cash flow yield for the companies that hold debt, have a large amount of cash and have preferred shares. Using enterprise value in calculating free cash flow yield provides a better measure when comparing of companies for possible investment. At Trading Online Markets LLC, we use market capitalization as the divisor to calculate free cash flow yield as one of our selection criteria for stocks on our Premium Members Watch List.
Comparing Free Cash Flow Yield

The table below compares the free cash flow yield for two quality companies, Accenture Ltd (ACN) and EMC (EMC). Accenture is a successful global consulting and IT outsourcing company. EMC is a manufacturer of storage devices for data centers and a developer of software that manages multiple computers, offers security services and document management for a number of industries. Each company generates significant cash flow and free cash flow. Since EMC is a manufacturer, they tend to have higher capital investment requirements than Accenture, a services company. This may lower their free cash flow on a relative basis. In addition, EMC has a debt to equity ratio of 26.5%, while Accenture essentially has no long-term debt.

When analyzing companies, I like to see the free cash flow yield be at least 10%. As shown below both companies have free cash flow yields above this threshold, indicating they are potentially good investment opportunities. The fact that Accenture’s free cash flow yield is higher than EMC’s, does not necessarily make them a better choice. However, it does offer an excellent way to compare the potential performance of several companies. The free cash flow yield measures the ability to generate cash, the risk in the balance sheet and the share price, all in one meaningful statistic.
Earnings Yield Comparisons ($000)
Capital Expenditures <>$303,464
Earnings Yield Calculations Accenture (ACN) as of 3/25/2009 EMC (EMC) as of 3/25/2009
Total Cash Flow from Operating Activities $3,302,851 $3,565,008
$695,899
Free Cash Flow $2,999,387 $2,869,109
Market Capitalization $19,270,000 $23,880,000
Free Cash Flow Yield using Market Cap 15.6% 12.0%
Enterprise Value $15,550,000 $19,360,000
Free Cash Flow Yield using Enterprise Value 19.3% 14.8%
Debt to Equity Ratio 0.01% 26.5%
The Bottom Line

The free cash flow yield measure is probably the best fundamental statistic available. By basing it on a company’s cash flow, it removes the accounting treatment that is inherent in our current financial statements. Free cash flow measures the ability of the company to generate excess cash and provide money to reinvest in the company to help it grow further. Using the enterprise value incorporates the total value of a company used to generate profits. Moreover, the free cash flow yield is not hard to calculate. The information is available from the widely used financial sites as well as a company’s financial statements. Investors will do themselves a service by comparing the free cash flow yield of companies they are considering or own.