Understanding Free Cash Flow Yield

You may be familiar with such stock valuation measures as price-to-earnings (P/E) ratio and book value per share. A lesser known and, therefore, less widely used measure is free cash flow yield. Here is what you need to know about free cash flow and free cash flow yield and how you can use these valuable tools in your stock analysis.

Calculating Free Cash Flow and Free Cash Flow Yield

To calculate a company's free cash flow, go to its annual cash flow statement, which you will find in its annual shareholders' report or its annual 10-K filing with the SEC (at www.sec.gov ). There are three main categories in the cash flow statement: cash generated by (used by) operations, cash generated by (used by) investing activities, and cash generated by (used by) financing activities.

Free cash flow is cash generated by operations less capital expenditures (which is a line item in the category labeled cash generated by or used by investing activities). If the resulting figure is positive, the company has free cash flow. If it is negative, your work is done, since the company is not generating free cash flow and therefore free cash flow yield will not be a relevant valuation measure for its stock. Assuming that the company has free cash flow, divide this figure by average shares outstanding to arrive at free cash flow per share.

For a more complete picture of a company's free cash flow history and prospects, calculate this figure for the last three years and for the most recent trailing 12 months (unless the latest financial results reported are for a full year). If you can, also project cash flow for the coming year and use these figures to estimate free cash flow for the period.

Free cash flow yield is a company's free cash flow per share divided by its stock price per share.

Why Free Cash Flow Matters

From an investment standpoint, whether or not a company generates free cash flow matters for several reasons.

First, free cash flow is cash available to reward shareholders by paying dividends and/or repurchasing stock.

Second, it is cash that can be used to strengthen a company's financial position by repaying debt and/or building cash balances.

Third, it is cash that can be used to grow the business, for example, by investing in research and development, revenue-producing capital projects, or acquisitions.

Fourth, a company whose operations generate more cash than it needs to maintain its business is better positioned to weather downturns and to take advantage of opportunities that may arise when less financially sound competitors falter in tough economic times. Also, the more cash a company generates and the stronger its balance sheet, the more easily it can borrow, even when money is tight and banks are reluctant to lend.

How to Use Free Cash Flow Yield in Your Investment Analysis

Once you have calculated a company's free cash flow yield (based on the most recent annually numbers available, on trailing 12 month figures or, best of all, on projected cash flow), compare this figure to comparable free cash flow yields for other companies in its industry and/or to free cash flow yields for other equity investments you are considering. Although there is no rule of thumb for free cash flow yield, in my opinion, a ratio that is 5% or higher is very good and a number approaching or exceeding 10% is excellent.

Free cash flow yield is only one investment tool to use in your stock analysis. As with any single stock valuation measure, it is not perfect. For example, free cash flow yield won't tell you how a company's next quarter is going to look, whether it will be able to meet its growth targets, or even if it will use its cash productively. However, a company that consistently generates more cash than is needed to maintain its business, if it is well managed and uses that cash wisely, should be well positioned to weather hard times, to take advantage of growth opportunities and to reward shareholders long term.

Sources:

www.investopedia.com , Free Cash Flow Yield Definition

www.tradingonlinemarkets.com , Free Cash Flow Yield

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