I wrote recently about the problems of relying too much on the P/E ratio for investment decisions. So what should you look to instead? There are lots of important fundamental factors to consider, but one particularly useful measure is the Free Cash Flow Yield. It is a measure of how much extra cash the company produces as a percent of the company’s total value.
Free cash flow is the lifeblood of companies. It is the left over cash that allows companies to pay out dividends, reduce debt, acquire other companies or invest in the future. It gives a company flexibility. The simplest way to calculate free cash flow is to take the cash flow from operations on the cash flow statement and subtract capital expenditures. This is the cash generated from its core business minus long term investments in things like new factories or trucks. It leaves out things like depreciation and amortization, restructuring or other accounting charges that can distort earnings even though they don’t represent an actual outflow of cash from the company.
The Free Cash Flow Yield is similar to earnings yield, which is the inverse of the P/E ratio (earnings per share/price). You can also invert the Free Cash Flow Yield to get the Free Cash Flow Ratio (free cash flow per share/price). Just as the P/E ratio tells you how much you will pay for each dollar of earnings, the Free Cash Flow Ratio tells you how much you pay for each dollar of free cash flow.
Though it may fluctuate from year to year, free cash flow is generally more difficult for management to manipulate than earnings. Many investors believe that free cash flow, even more than earnings per share, is what drives the value of a stock. A company with negative or zero free cash flow is treading water, while a company with a high Free Cash Flow Yield has its own built-in engine for growth. It allows companies to self-finance and grow without resorting too much to more costly debt or equity financing. The ability to generate a lot of cash is also a buffer against any problems that might arise.
One problem with Free Cash Flow Yield, however, is that it is not as useful for early stage companies that are investing so much that free cash flow is negative. Still, knowing that a company has negative free cash flow may be an important fact that is ignored if you only look at ratios like P/E, Price/Sales or Price/Book.
Also like P/E ratio, Free Cash Flow Yield alone does not provide enough information to make an investment decision. In many cases it might tell you as much about the company’s industry or its life cycle stage as it does about whether it is a good investment right now. But it is an important piece of the puzzle that might be missed by investors who mistakenly put too much emphasis on the P/E ratio. And as with any ratio, looking at the long-term trend is more meaningful then relying only on the current value.
The following chart highlights how P/E ratios and Free Cash Flow Yield or Ratio might lead to different conclusions when evaluating a few selected small cap stocks.
Wrist watch company Movado (MOV) and Big 5 Sporting Goods (BGFV) both have low P/Es around 12. But Movado’s Free Cash Flow Yield is more than seven times higher.
Looking at the Free Cash Flow Yield of technology stocks Stamps.com (STMP) and Cambrex (CBM) is also revealing. Though Cambrex is a slightly larger company with a low level of capital expenditures, Cambrex produces a lot more cash flow and has a significantly higher Free Cash Flow Yield.
Analyzing the Free Cash Flow Yield points to some very important questions: What does company plan to do with the free cash flow? What are the company’s growth opportunities? How good is the management at allocating capital? It may be that as a watch company Movado, despite its strong cash flow, has fewer clear growth opportunities than Big 5, which is a retail chain that can grow by adding more stores.
Free Cash Flow yield is one of the most important tools for investors analyzing a stock. While P/E ratio depends on all sorts of accounting assumptions, the Free Cash Flow Yield tries to show the actual cash available for growth or return to shareholders. This gives investors a good picture of the inner workings of the company and its ability to create value.
Note: To make things simpler, I’ve left out some details I might usually consider in calculating FCF yield such as changes in working capital or using enterprise value instead of market cap.