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 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. 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 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. 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 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. 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 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. 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 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 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 is a measure of a company's total value that spans the entire market rather than just the equity value. It includes all debt and equity-based ownership claims. This value, which is calculated as the market value of debt + market value of equity - cash and cash equivalents, is particularly relevant when valuing a takeover.= 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 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 operating cash flow found in the cash flow statement.
- FCFF= Operating cash flowOperating Cash FlowCash 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 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
Investors who consider cash generation by a firm as a better representation of its operations like to analyze the cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.. 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. Revenue and earnings can be manipulated, but firms cannot manipulate cash flows. For example, earnings per share can be superficially improved through 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..
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 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.
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 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 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 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 in spite of promising growth prospects.
Free Cash Flow Yield Video
This article has been a guide to Free Cash Flow Yield (FCFY). We discuss the formula to calculate free cash flow yield along with examples from Amazon, Alphabet, Apple & Microsoft. You may have a look at these articles below to learn more about valuations –