What is Free Cash Flow Yield (FCFY)
Free cash flow yield is a financial ratio that measures how much cash flow the company has in case of its liquidation or other obligations by comparing the free cash flow per share with the market price per share and indicates the level of cash flow the company will earn against its share market value.
The higher the ratio, the more attractive the investment is since it indicates that investors pay less for each free cash flow unit.
Many stakeholders consider cash flow a more accurate measure of a company’s performance than 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 valueIntrinsic ValueIntrinsic value is defined as the net present value of all future free cash flows to equity (FCFE) generated by a company over the course of its existence. It reflects the true value of the company that underlies the stock, i.e. the amount of money that might be received if the company and all of its assets were sold today.. One can use the cash left over to pay dividends and interest, reducing debt, acquisitions, and future investments.
Table of contents
- Free Cash Flow Yield is a financial ratio that determines the company’s cash flow in case of its liquidation or other obligations by comparing the free cash flow per share with the market price per share.
- It shows the cash flow level the company may earn against the share market value.
- The equity shareholders and a firm perspective may evaluate the Free Cash Flow Yield.
- It is a crucial financial tool that clarifies the firm’s financial health more than net income. Moreover, it is valuable regarding the value received against the investment.
Calculation of Free Cash Flow Yield (FCFY)
The equity shareholdersEquity ShareholdersShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period. and a firm perspective can calculate free cash flow yield. However, while computing free cash flow yield, we must ensure that the denominator and numerator are consistent with the firm or equity valueEquity ValueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding..
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 FCFEFCFEFCFE (Free Cash Flow to Equity) determines the remaining cash with the company's investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company's equity capital management = 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. Finally, for maintaining consistency in calculations, equity reinvestmentReinvestmentReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio. 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 dividendPreferred DividendPreferred dividends refer to the amount of dividends payable on preferred stock from profits earned by the company, and preferred stockholders have priority in receiving such dividends over common stockholders.)
Net capital spending is considered to arrive at the net cash outflow from investment in fixed assets. Again, since the increase in the working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" drain a firm’s cash flows while the decrease in working capital frees 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 FCFFFCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.= FCFE + Interest expense (1- tax rate) + (principal repayments –new debt issued)+ Preferred dividend
- And Enterprise ValueEnterprise ValueEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.= Market Capitalization of equity+ Market value of preferred equity + Debit – Cash
From a firm’s perspective, this calculation 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 firm investors, while the market capitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share. of the portion owned by shareholders.
Since we are considering all claim holders, we need to add to FCFE all the payments made to lenders and preferred shareholders like interest expense, net debtNet DebtDebt minus cash and cash equivalents equals net debt, which is the amount of debt a company has in comparison to its liquid assets. It is a metric that is used to evaluate a firm's financial liquidity and aids in determining if the company can meet its obligations by comparing liquid assets to total debt. repayments, and preferred dividend.
A simpler way of calculating FCFF is by subtracting capital expenditure from the operating cash flow found in the cash flow statement.
- FCFF= Cash flow from operationsCash flow from operationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital. – 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 leasesLeasesLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”, trailing twelve months, FCFY is negative despite the company showing a positive cash flow of $1.2 billion and $3.4 billion for FY17 and FY16, respectively, in the cash flow statement.
Table 1: FCFY calculation for Amazon
Source: FY17 Annual Report, Amazon
Investors who consider cash generation by a firm to better represent its operations like analyzing the cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.. For them, FCFY is a more appropriate indicator against the P/E ratioP/E RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. or EV/EBITDA ratioEV/EBITDA RatioEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries. since cash flow is a better return representation. One can manipulate revenue and earnings, but firms cannot manipulate cash flows. For example, corporate share buybacksShare BuybacksShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company. can superficially improve earnings per share.
Higher the amount of free cash flowCash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX)., 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 opportunitiesOrganic Growth OpportunitiesOrganic growth is the rate of growth that a company achieves by increasing sales revenue by increasing volume of products sold or by achieving greater operational efficiency leading to a reduction in the cost of production or any other internal improvement., 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 ratioForward P/E RatioForward PE ratio uses the forecasted earnings per share of the company over the next 12 months for calculating the price-earnings ratio. Forward PE ratio formula = Price per share/Projected earnings per share and current P/E, Apple remains a safer bet considering its high free cash flow yield. A more relevant measure would be to check the forward FCFY for better decision-making. However, comparing companies within the same industry is more important while doing the relative valuation.
Free Cash Flow Yield (FCFY) is an important financial metric that provides a more vivid picture of the firm’s financial health than net income. This ratio is valuable as it relates to the value received against the investment made. Compared to its assets, a company with a high cash flow may be overpriced in the market, leading to a lower FCFY and vice versa.
FCFY helps in analyzing the strength of a firm. A negative free cash flow yield or negative free cash flow may indicate that the firm is not liquid enough and would need external funding to continue 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 costly external financing for development, thus shareholder valueShareholder ValueShareholder's value is the value that company shareholders receive as dividends and stock price appreciation due to better decision-making by the management that ultimately results in a company's growth in sales and profit.. However, FCFY cannot alone be considered 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 the Capex definitionCapex DefinitionCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.. Hence, these firms may report lower FCFY despite promising growth prospects.
Free Cash Flow Yield Video
Frequently Asked Questions (FAQs)
A 12% yield means a company makes 12% market capitalization annually in Free Cash Flow. Typically, higher results are fascinating since they indicate that investors pay less for cash flow for each unit.
Why is Free Cash Flow Yield significant?
One may primarily use the Free Cash Flow Yield to determine the cash paid to the stakeholders by dividends and interest. It is essential as it helps to understand the money a company has to pay dividends to shareholders.
A negative Free Cash Flow number shows the company cannot create enough cash to back the business. Still, major small businesses need a positive Free Cash Flow since they invest primarily for rapid venture growth.
An Unlevered Free Cash Flow Yield is the business’s money before paying all the financial obligations. A high Unlevered Free Cash Flow Yield suggests that a company has enough accessible cash to reinvest in the industry or pay to equity holders.
This article is a guide to Free Cash Flow Yield (FCFY). We discuss formula to calculate free cash flow yield and examples from Amazon, Alphabet, and Apple. You may have a look at these articles below to learn more about valuations: –