The Free Cash Flow Yield explained.

The Free Cash Flow Yield is a “solvency ratio” that measures how much money a company makes in free cash flow relative to its market capitalisation. Many stakeholders, including myself, believe that free cash flow is a more reliable measure than Earnings Per Share. This is because Cash flow is a better indicator of a company’s ability to sustain its operations.

Free Cash Flow is one of the most significant financial metrics that investors and analysts use. It shows us how much capital a business has to pay down its debts or reinvest in the company.

Since Free Cash Flow is such a critical component of financial analysis, we need a way to see how the market values it. The FCF yield is the answer to that. Comparing the FCF generated against the market cap, we can see how efficiently capital is being used in relation to the value of the company.

The higher the FCF yield, the more attractive the investment becomes because it indicates that investors pay less for each free cash flow unit. From a company perspective, the higher the FCF yield, the more flexibility the business has in pursuing organic growth, reducing debt, and rewarding shareholders.

Some investors look at the FCF yield as an indirect representation of the returns they can expect to receive. The yield helps investors understand the likelihood of recouping their investment by measuring the amount of FCF generated per dollar invested.

The lower the ratio, the less attractive a company is as an investment. It means investors are not getting a very good return in exchange for what they put in.

Using the FCF yield can help determe if a company’s shares are undervalued or overvalued. For instance, if the FCF of a company stays steady, a higher yield can be generated from a decrease in share price. This happens because, with a smaller market cap, a shareholder can get more FCF in proportion to the share price.

What is the Free Cash Flow Yield formula?

• FCF Yield = Free Cash Flow ÷ Market Cap x 100
• Formulated on a per-share basis. Divide the FCF per-share by the share price to give you the yield.

Free Cash Flow is simply Cash from Operations – Capital Expenditures.

*A 10% FCF yield means a company makes 10% market capitalisation annually in Free Cash Flow.

How to use the FCF Yield?

When using the FCF Yield it is important to measure companies in the same industry and similar stages in the business cycle. In the example below, let’s examine three companies to determine which one may provide a better return based on FCF yield.

	Company A	Company B	Company C
Free Cash Flow	$1.55 billion	$355 million	$780 million
Market Cap	$10.8 billion	$12.3 billion	$7.9 billion
FCF Yield %	14.35%	2.84%	9.8%

The yield tells investors the percentage amount of Free Cash Flow that constitutes a company’s Market Cap. For instance, Company A has a yield of 14.35% of FCF relative to its Market Cap. Meaning the company makes 14.35% market capitalisation annually in Free Cash Flow

When evaluating a company’s value, it’s essential to consider its free cash flow per-share in relation to its share price. The higher the ratio of free cash flow to market cap, the better it is for investors. It indicates that the company generates a significant portion of its value from the free cash flow it generates.

Company A has a greater percentage of FCF which can be utilized for reinvestment or distributed among shareholders.

Another example below shows how we can use the FCF Yield to investigate a company to see how it is evolving. Horizontally analysing the numbers can reveal whether a company has an improving or declining yield.

Company A	2021	2022	2023
FCF Per-Share	$0.92	$0.88	$0.85
Share Price	$7.90	$8.75	$11.13
FCF Yield %	11.64%	10%	7.63%

For this example we have used a declining FCF Yield to demonstrate how FCF decreased yet share price increased. Investors may perceive a lower yield as an indication of overvaluation, but this may not be the entire picture.

A low FCF yield suggests that the stock is overvalued because the company is not generating sufficient cash in proportion to the share price. However, it is essential to consider the context of the situation. This is why we prioritize fundamental analysis, to understand the reasons behind the decline.

If the company is in a growth phase and reinvesting heavily back into itself, free cash flow will be impacted. This is because, as a company expands, its working capital cycles change. It may take on more inventory, accounts payable and receivables change, which can affect free cash flow.

In Summary…

Many investors and analysts rely on the FCF yield is an important metric to consider when evaluating financial performance. However, I don’t think the FCF yield should be used in isolation without understanding how FCF can impact shareholder value.

Focusing on increasing free cash flow in the short term can lead to missed growth opportunities and ultimately lower TSR. When companies use FCF as a performance measure, managers may be incentivized to make decisions that are not in the best interest of long-term shareholder value creation.

If a company is focused on growth, it is likely to have lower FCF yields. This is because the market perceives a company that is already generating free cash flow and showing positive long-term growth as an opportunity, and prices it accordingly. The higher the share price, the more it will impact the FCF yield, creating a dislocation between FCF and market cap.

The reverse of this is where investors may find an undervalued opportunity. As a share price decreases the yield rises giving shareholders more FCF for every dollar invested.

The free cash flow yield matters because companies that generate more cash flow than they spend are less likely to depend on the capital markets for external financing. You want to find companies with positive, growing, and consistent free cash flow. Companies with higher yields are self-sufficient and able to fund their growth strategies and protect themselves against competitors.