What is Free Cash Flow Yield (FCFY)
Free cash flow yield is a financial ratio which measures that how much cash flow the company has in case of its liquidation or other obligations by comparing the free cash flow per share with market price per share and indicates the level of cash flow company is going to earn against its market value of the share.
The higher the ratio, the more attractive the investment is since it gives an indication that investors are paying less for each unit of free cash flow.
Many stakeholders consider cash flow as a more accurate measure of a company’s performance compared to earnings since cash flow represents a firm’s ability to sustain its operations. Furthermore, free cash flow gives the company flexibility to increase its intrinsic value since the cash leftover can be used for paying dividends and interest, reducing debt, acquisitions, and future investments.
Calculation of Free Cash Flow Yield (FCFY)
Free Cash Flow Yield can be calculated from the equity shareholders as well as a firm perspective. While computing FCFY we need to make sure that denominator and numerator are consistent with both of them being either equity value or firm value.
Formula #1 (FCFE)
From the perspective of common equity holders, the Free Cash Flow Yield calculation is as follows:
- FCFY= Free Cash Flow to Equity (FCFE) per share/Market Price per share
- Where FCFE = Net Income + Non-recurring expenses – Non-operating income + Non-cash operating expenses – Equity Reinvestment
Non-cash operating expenses are added back since they are accounting expenses but not cash expenses. Further, non-recurring or non-operating income/expenses are excluded to derive recurring cash flow from core operations. For maintaining consistency in calculations, equity reinvestment needs are subtracted from the gross cash flow to arrive at free cash flow available to equity holders.
Equity Reinvestment= (Capital expenditure – Depreciation) + change in non-cash working capital – (new debt issue – debt repayment) – (new preferred stock issued – preferred dividend)
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Net capital spending is considered to arrive at the net cash outflow from investment in fixed assets. Again, since the increase in the working capital drain a firm’s cash flows while the decrease in working capital free up available cash flows, we are concerned with cash flow changes due to changes in working capital. To the extent the firm finances this reinvestment by a mix of equity, debt, and preferred equity, debt holders’ and preferred shareholders’ investment within this total reinvestment are subtracted to arrive at net reinvestment by equity.
Formula #2 (FCFF)
Free Cash Flow Yield calculation from a firm’s perspective (equity holders, preferred shareholders, and debt holders) is as follows:
- FCFY= Free cash flow to firm (FCFF) /Enterprise Value
- Where FCFF= FCFE + Interest expense (1- tax rate) + (principal repayments –new debt issued)+ Preferred dividend
- And Enterprise Value= Market Capitalization of equity+ Market value of preferred equity + Debit – Cash
This calculation from a firm’s perspective represents free cash flow left to all claim holders against the investment made. Here the investment is depicted by the Enterprise value, which is the market value of investments by all the investors of the firm while market capitalization of the portion owned by shareholders.
Since we are considering all claim holders, we need to add back to FCFE all the payments made to lenders and preferred shareholders like interest expense, net debt repayments, and preferred dividend.
A simpler way of calculating FCFF is by subtracting capital expenditure from operating cash flow found in the cash flow statement.
- FCFF= Operating cash flow – capital expenditure
Example of Free Cash Flow Yield (FCFY)
In the case of Amazon, when considering the property and equipment acquired under capital and built-to-suit leases, trailing twelve months, FCFY is negative in spite of the company showing a positive cash flow of $1.2 bn and $3.4 bn for FY17 and FY16, respectively, in cash flow statement.
Table 1: FCFY calculation for Amazon
Source: FY17 Annual Report, Amazon
FCFY Comparision
Investors who consider cash generation by a firm as a better representation of its operations like to analyze the cash flow statement. For them, FCFY is a more appropriate indicator against the P/E ratio or EV/EBITDA ratio since cash flow is a better return representation. Revenue and earnings can be manipulated, but firms cannot manipulate cash flows. For example, earnings per share can be superficially improved through corporate share buybacks.
Higher the amount of free cash flow, the greater the flexibility of the company to pursue growth opportunities during good times and smoothly tide over difficulties during bad times. A company with a steady free cash flow yield can consider dividend payments, share buybacks, inorganic and organic growth opportunities, and debt reduction. Thus cash flow yield provides a better indication of long-term valuation.
Table 2. Comparison Across Companies – FCFY
A look at Table 2 reveals that while Alphabet remains the most attractive stock based on the difference between forward P/E ratio and current P/E, Apple remains a safer bet considering high free cash flow yield. A more relevant measure would be to check the forward FCFY for better decision making. However, it is more important to compare companies within the same industry while doing the relative valuation.
Conclusion
Free cash flow yield (FCFY) is an important financial metric that provides a more vivid picture of the financial health of the firm as compared to net income. This ratio is valuable as it relates to the value received against the investment made. A company with a high cash flow compared to its assets may be overpriced in the market, leading to a lower FCFY and vice versa.
FCFY helps in analyzing the strength of a firm. Negative free cash flow yield or negative free cash flow may indicate that the firm is not liquid enough in its operations and would need external funding for continuing its operations. The continuous decline in free cash flow may impact future earnings growth. In contrast, rising free cash flow allows companies to self-finance without resorting to costlier external financing for growth, thus shareholder value. However, FCFY cannot alone be considered as the only metric for making investment decisions. Firms in the high growth phase may have decent earnings, but their cash flows may get fully consumed by Capex definition. Hence, these firms may report lower FCFY in spite of promising growth prospects.
Free Cash Flow Yield Video
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