Why is the Free cash flow yield important?

Today I want to talk about the Free cash flow yield and discuss why it is important for value investors.

In theory value investing is easy.

You buy an undervalued stock, you reinvest the dividends and you repeat for a long time.

The trouble is that you cannot be certain when the stocks that you are looking at are really undervalued – perhaps the company had just one year of good earnings that skews the Price to earnings ratio.

That is why I prefer to look at the Free cash flow. The Free cash flow is the amount of money that the company is making after paying off costs to maintain or expand the company’s asset base.

The Free cash flow is the money that the company can spend to pay dividends or to buy back shares.

OK, I get it, but what has this got to do with value?

Quite a lot, it turns out.

The Free cash flow per share complements the earnings per share and gives a broader picture of the money made.

Because it cannot be as easily manipulated as the earnings per share, it gives a fairer picture of how much money that flows into the company.

How do you calculate the Free cash flow yield?

First of all you need to find the Free cash flow. Go to the company’s web site and download the most recent annual report.

In there you will find something that is called Comprehensive cash flow statement.

You take the Cash flow from operating activities and you enter it into Excel. Then you will find something called Investment in plant, property and equipment. Then finally you add the two together, like so:

Figure 1. Screenshot of Microsoft Excel showing how to calculate the Free cash flow from the Operational cash flow and the Capital expenditures.

Then you need to find the number of shares that the company has outstanding and you divide the Free cash flow with this number.

Then it turns out that the Free cash flow yield is easy:

You divide the Free cash flow per share with the price per share, like so:

Figure 2. Formula for calculataing the Free cash flow yield by dividing the Free cash flow per share by the Share price.

What you end up with is a percentage that you can use as a valuation metric.

In my experience, a free cash flow yield above 5 per cent indicates that the share is undervalued, if it is between 3 and 5 per cent it is worth considering and if it is below 3 per cent the share is outright expensive.

That is the reason why you want to consider the Free cash flow yield as another value metric.

Why not give it a go?