Free Cash Flow Yield

Why should I care about free cash flow yields?

For markets: Free cash flow yields help investors gauge a company’s cash generation capability relative to its size. All things being equal, a higher free cash flow yield might suggest an undervalued company or one that has optionality when it comes to the use of its cash – potentially representing an attractive opportunity to investors. A company with a low free cash flow yield might indicate a firm with less financial flexibility or one whose cash generation is highly valued by investors. A company with a negative free cash flow yield is burning through, rather than generating money.

Zooming in: Free cash flow yield is an important measure for evaluating whether a company has sufficient cash flows to support dividends, buy back shares, pay off debt, or reinvest in its business operations. This yield provides a more tangible sense of a company's financial strength than earnings alone, which can be affected by non-cash accounting measures. For example, a company with a high free cash flow yield might be more likely to increase dividend payments or pursue acquisitions without needing additional financing.

What is a good FCF yield?

A free cash flow (FCF) yield offers a valuable gauge for assessing how much cash a company generates relative to its value. Investors use this financial metric to assess the attractiveness of a company relative to its cash-generating capability.

Generally, a higher FCF yield signals that the company is generating substantial cash flow compared to its value, which investors find attractive. It’s indicative of a company efficiently managing its resources and generating sufficient cash to fund growth initiatives, pay dividends, or reduce debt. The other side of the FCF yield equation, though, is the value of the company. A high-cash-generating company might only have a high FCF yield if investors have a relatively conservative view of its valuation. That’s partly why high FCF yields are more common in stable, mature industries where cash flows are predictable.

A lower FCF yield might imply that the company's valuation is high relative to the cash it generates. That could be due to high growth expectations baked into valuation, or it might reflect challenges that limit cash generation meaning the company might be overvalued. An investor would look at a company’s financials to understand whether a low FCF yield is down to high short-term cash expenses (capital expenditure, other expansion plans) or longer-term challenges that point to inefficiencies in generating cash.

The average FCF yield of S&P 500 companies is 3.6%. So you might determine that a higher FCF yield is good and a lower one is bad. But what constitutes a good FCF yield depends on a bunch of other factors, too.

An important one is growth versus mature companies or industries. In high-growth sectors, investors might expect to see lower FCF yields due to firms requiring reinvestment that depress free cash flow on the promise of higher future returns. In more mature sectors, like utilities or consumer staples, investors might expect to see higher FCF yields, reflecting stable earnings and less need for major capital expenditures.

How do I calculate free cash flow yield?

There are two ways to calculate a company’s FCF yield, depending on whether you’re calculating the FCF yield available to equity holders (FCFe) or the FCF yield available to the entire firm – debt and equity holders – (FCFf).

Free cash flow yield to equity holders (FCFe, levered)

• FCFe yield = Free cash flow / Market capitalization

where:

• Free cash flow (FCF): cash flow from operations (CFO) minus cash flow from investing activity (CFI) and interest payments (if not included in CFO). Historical data is shown on a company’s cash flow statement. Professional analysts tend to have forecasts for these figures they’ll use in their calculations.
• Market capitalization: the total market value of a company's stock, calculated as the current share price multiplied by the total number of shares.

Free cash flow yield to the firm (FCFf, unlevered)

• FCFf yield = Free cash flow / Enterprise value

where:

• Free cash flow (FCF): cash flow from operations (CFO) minus cash flow from investing activity (CFI) but before interest payments. Historical data is shown on a company’s cash flow statement. Professional analysts tend to have forecasts for these figures they’ll use in their calculations.
• Enterprise value (EV): market capitalization plus net debt.

For a proxy that’ll get you close to the FCFf yield, you can invert the company’s EV/EBITDA multiple. I.e. a company at 20x EV/EBITDA has a roughly 5% (1/20) FCFf yield.

FCF yield calculation example

Let’s assume a Company X has the following financials:

• Free cash flow: $200 million
• Annual interest payment: $20 million
• Current share price: $50
• Number of shares outstanding: 20 million
• Total debt: $300 million
• Cash and cash equivalents: $100 million

First, calculate market cap or EV.

Then, calculate the appropriate yield.

This example illustrates how FCF yield can vary depending on whether it’s measured relative to the entire firm or just shareholders. Each method provides slightly different insights into the financial health and potential attractiveness of a company.

What is the difference between FCFf yield (unlevered) and FCFe yield (levered)?

The free cash flow to the firm (FCFf) yield is before considering financial leverage – i.e. the effect of debt on a company’s cash flow and valuation – and free cash flow to equity (FCFe) yield reflects the impact of debt. Put another way, FCFf yield considers the cash flow available to the entire company, whereas the FCFe yield considers the cash flow available only to shareholders – i.e. after debtholders have been paid their interest.

Comparison between FCFf and FCFe yields.

When to use FCF yield?

Knowing when to use FCF yield can provide insight into a company’s valuation and potential returns. Here are scenarios and considerations for using FCF yield:

1. Valuation comparison: FCF yield is useful when comparing companies within the same industry to identify which stocks might be under or overvalued. A higher FCF yield may indicate that a company is generating more cash per unit of market value, making it potentially undervalued. Conversely, a low FCF yield might indicate overvaluation.

2. Dividend sustainability assessment: FCF yield is a crucial measure for income-focused investors, especially those interested in dividend-paying stocks. It helps assess whether a company generates enough cash to sustain or grow its dividends. If the FCF yield is high, it suggests that the company can comfortably cover its dividend payments, which might be seen as a sign of strong financial health and stability.

3. Investment evaluation: FCF yield can be used as a screening tool to identify potential investment opportunities. Investors looking for cash-rich companies that can fund growth, reduce debt, or weather economic downturns without external financing, might find FCF yield a helpful metric.

4. M&A analysis: In the context of mergers and acquisitions, FCF yield can help acquirers evaluate target companies. A strong FCF yield in a potential acquisition target suggests that it can generate enough cash to justify the purchase and potentially pay down the debt incurred to finance the acquisition.

5. Economic sensitivity analysis: During periods of economic uncertainty or market volatility, companies with a high FCF yield may be better positioned to endure downturns. Investors might use FCF yield during such times to identify companies that are likely to remain financially sound despite challenging conditions.

Frequently Asked Questions about free cash flow yields

Why is FCFf preferred over FCFe?

Free cash flow to the firm (FCFf) is often preferred over free cash flow to equity (FCFe) because it provides a more comprehensive view of a company’s cash generation capability. FCFf measures the cash flows available to all capital providers, both debt and equity holders, without the distortions caused by different capital structures. This makes FCFf a more stable and consistent metric, particularly useful for comparing companies across different industries or with varying debt levels.

What is the difference between cash flow and earnings?

Cash flow and earnings measure different aspects of a company's financial health. Earnings, or net income, are calculated according to accounting standards and include non-cash expenses like depreciation and amortization. Cash flow, however, reflects the actual amount of cash being generated by the company's operations. It provides a clearer picture of a company’s liquidity and its ability to finance operations, invest in new projects, and return money to shareholders.

Why is FCF yield considered a value metric?

FCF yield is considered a value metric because it is a direct indicator of the value investors place on the company's ability to generate cash. A higher FCF yield can indicate that a company is undervalued, suggesting that an investor might pay less for each dollar of cash flow generated. This makes it an essential tool for value investors looking for stocks that might be trading below their intrinsic value.

Can a company have a negative FCF yield?

Yes, a company can have a negative FCF yield if it reports negative free cash flows. Negative free cash flow can occur if a company has heavy capital expenditures, significant increases in working capital, or if it is experiencing operational difficulties that impair its ability to generate cash. A negative FCF yield indicates that the company is consuming more cash than it's generating, which might raise concerns about its long-term financial sustainability and growth prospects.