Free cash flow yield
Free cash flow yield is a free cash flow per share divided by current market price per share. It works similarly to earnings yield. "Free cash flow is a desirable characteristic in stocks, particularly thosewith above-average growth rates. It is a sign of financial flexibility andan associated ability to perpetuate growth. The higher the free cash flow yield is the more attractive investment is, because investors want to pay less for higher profits." ( Brent R. Grover, 1996, p. 15-16).
The power of Free Cash Flow Yeld "Valuation metrics offer investors a simple way to assess a company’s worth by looking at its sales, earnings and cash flow. These metrics compare the company’s value to the market’s assessment of the company to determine if an investment is attractive." (M.Mack, 2016, p. 1)
The equation is:
where:
- FCFY - free cash flow yield,
- CFpS - cash flow per share,
- MPpS - market price per share.
The higher the free cash flow yield is the more attractive investment is, because investors want to pay less for higher profits.
The free cash flow yield is based on actual cash flow, not only on earnings which can, but don't have to be related to real cash. Therefore, cash flow better explains how company operates and whether it is able to sustain problems.
Free Cash Flow Yield
A lot of people who investing, use the special technique that is called PE-Price Earning (G. Christy, 2008, p. 123-125).
They use it to calculate share prices. At first they estimate current period of time (for example a year) EPS-(market rate determining the share of profit per share) and after multiply earning per share by the stock's Price Earning Ratio. Investors will use Free cash flow yield to estimate the benefits of changes in share prices on the change in the value of the spectral share from the forecasted changes (G. Christy, 2008 p. 123-125).
One of the options to calculate the enterprise multiple (the enterprise yield) is a Free Cash Flow Yield, where the denominator is total enterprise value but free cash flow is substituted by the enterprise multiple's EBITDA. In the numerator we use Free Cash Flow, because if amortization and depreciation are noncash, historical investment decisions are reflected in accounting charges, after the acquisition a level of maintenance capital expenditure will be needed. In that case, after removal of capital expenditures (so also the maintenance capital expenditure is accounted) we receive the operating cash flow, which in other words is Free Cash Flow (W. Grey, T. Carlise, 2013, p. 145).
Formula
Below are some useful designs:
Free Cash Flow Yield = Free cash flow per share / Stock Price} (G. C. Christy, 2008, p. 123-125)
Free Cash Flow Yield = FCF/TEV (G. C. Christy, 2008, p. 123-125)
TEV = market capitalization + total debt - excess cash + preferred stock + minority interests (W. Grey, T. Carlise 2013 p. 145).
Excess cash = cash + current assets - current liabilities (W. Grey, T. Carlise 2013 p. 145).
EBITIDA = earnings before interest, taxes, depreciation, and amortization (W. Grey, T. Carlise 2013 p. 145).
Free Cash Flow (FCF)= net income + depreciation and amortization - working capital change - capital expenditures (W. Grey, T. Carlise 2013 p. 145).
Investors use Free Cash Flow Yield to assess stock price change which is a result of the changes related to the estimated company's operations in the future. This is a variance between current Free Cash Flow per share and assumption of following year's Free Cash Flow per share. Below we can find the formula to assume the influence of a change in Free Cash Flow per share of the company (G. Christy, 2008 p. 123-125):
Share Value due to Operations=(Next Year's FCS - Current Year's FCS) / (Current Year's FCS) (G. Christy, 2008 p. 123-125)
Let's assume that the price of XYZ's stock's is $38, the value of the share increases by 12% ($4,56). However, return of the rate is only one of the three factors that will impact future stock price of XYZ's. The 12% estimate presents merely changes in XYZ's stock price as an effect of the change in Free Cash flow generated by all company operations. The twelve percent estimation does not include:
1. financial structure changes of the company,
2. changes of interest rate level (G. Christy, 2008 p. 123-125).
Free Cash Flow Yield is a revers, "Cash Flow" Version of the (PE) (G. Christy, 2008 p. 123-125).
Price-earnings ratio
The price-earnings ratio (P/E ratio) is a company's valuation ratio which is measuring actually share price with reference to its per-share earnings. The price-earnings factor is also sometimes called the price multiple or the earnings multiple (K. Anderson 2012).
Price-Earning Ratio (PE)Price-Earning Ratio=(Stock price)/(Earning per sharea) (G. Christy, 2008 p. 123-125)
Free Cash Flow vs Price Earning Ratio
The growing importance and effectiveness of free cash flow is particularly high compared to other popular investment indicators, especially in the case of earnings and their derivatives, price / earnings ratio. Why are the cash Flow and p / Es eclipse gains the most useful reference point for security selection and enterprise management? Most of the answers lie in accounting: the processes in which the company represents its financial composting (W. Printest, L. MaCelland 2007 p. 12-13).
Examples of Free cash flow yield
- For example, a company's free cash flow yield is calculated by taking its free cash flow per share and dividing it by the current market price per share. For example, if a company has a free cash flow of $2 per share and a current market price of $10 per share, then its free cash flow yield would be 20%.
- Another example would be a company with a free cash flow of $5 per share and a current market price of $25 per share. In this case, the free cash flow yield would be 20%.
- A third example could be a company with a free cash flow of $10 per share and a current market price of $50 per share. The free cash flow yield in this case would be 20%.
- Finally, a company with a free cash flow of $20 per share and a current market price of $100 per share would have a free cash flow yield of 20%.
Advantages of Free cash flow yield
Free cash flow yield is an important metric for investors to consider when evaluating potential investments. It offers several advantages over other metrics such as earnings yield. These advantages include:
- It provides a more accurate picture of cash flow since it subtracts out capital expenditures, giving a better indication of the financial health of the company.
- It can be used to assess the potential return on investment (ROI) of a company since it takes into account the cash flow generated by the company.
- It is an indicator of the company's ability to sustain growth, as it measures the amount of cash available to reinvest in the company.
- It can be used to compare the value of different companies, as the free cash flow yield can be compared to the market price of a company's shares.
- It is less volatile than earnings yield, as it does not take into account one-time events such as stock buybacks.
Limitations of Free cash flow yield
- Free cash flow yield can be misleading as it does not take into account non-cash expenses, such as depreciation and amortization.
- The market price of a stock can be volatile and not always reflect the true value of the company. As such, the free cash flow yield can be unreliable as it is based on the current stock price.
- Free cash flow yield does not take into account future cash flows, which may be more or less reliable depending on the company’s future prospects.
- Free cash flow yield does not take into account the risk of a company, which can affect the expected returns from an investment.
- Free cash flow yield does not consider the company’s capital structure, which can have an impact on the company’s free cash flow.
Other approaches related to Free cash flow yield include:
- Cash flow return on investment (CFROI): CFROI is a measure of cash flow return relative to the value of the investment. It takes into account the cost of capital, investments in fixed assets and other operating expenses.
- Economic Value Added (EVA): EVA is a measure of a company’s economic profit or loss, calculated as the difference between the company’s return on capital employed and its cost of capital.
- Operating Cash Flow to Enterprise Value (OCF/EV): OCF/EV is a measure of a company’s operating cash flow relative to its enterprise value. It can be used to compare companies in different industries and help identify undervalued and overvalued stocks.
- Cash Flow Yield (CFY): CFY is a measure of the cash flow generated by a company relative to its market value. It can be used to compare companies in different industries and help identify undervalued and overvalued stocks.
In summary, other approaches related to Free cash flow yield include Cash flow return on investment (CFROI), Economic Value Added (EVA), Operating Cash Flow to Enterprise Value (OCF/EV) and Cash Flow Yield (CFY). All of these measures are used to help identify undervalued and overvalued stocks and compare companies in different industries.
| Free cash flow yield — recommended articles |
| WACC — Market value ratios — Net yield — Gordon Growth Model — Plowback Ratio — Market Risk Premium — Return on common equity — Termination cash flow — Earnings Multiplier |
References
- Anderson K., (2012), The Essential P/E, Understanding the stock market through the price-earning ratio, Harriman House LTD, Grate Britain, p. 19.
- Brent R. Grover, (1996), Companies With Strong Free Cash Flow Yield And Other Positive Characteristics, "Black Book - Bernstein Disciplined-Strategies Monitor", p. 15-16.
- Christy G., (2008)., Seeing Through the Accounting Fog Machine to Find Great Stocks, John Wiley & Sons, Hoboken, New Jersey, p. 123-125.
- Drake P., (2018), What is free cash flow and how do I calculate it ?, p. 1-4
- Grey W. Carlisle T. (2013), Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, John Wiley & Sons, Hoboken, New Jersey, p. 145.
- Mack M., (2016), The Power of Free Cash Flow Yield, "Portfolio Manager", p. 1.
- Printest W. MaClelland L., (2007), Free Cash Flow and Shareholder Yield, John Wiley & Sons, Hoboken, New Jersey, p. 7-11.
- Richardson S., (2006), Over-investment of free cash flow, "Review of Accounting Studies", 11(2-3) p. 159-189.
- Shweser K., (2008), Free Cash Flow Valuation, Nr 12, p. 2-45.
Author: Jakub Pałkowski, Joanna Krygowska
