Free Cash Flow YieldWhat is it and how it can help in your investing decisions

So you’re looking to invest in some stock offerings and have started your research.

You set aside your funds, researched which stocks are worth investing in, and have looked into how you can become a shareholder/investor.

But wait, how do you identify which stocks are worth it?

Investing in stocks always carries a risk.

You never know when the economy might suddenly crash, and the business you invested in loses its value.

But hey, most people would say that the returns could be high enough to make investing appealing.

The question now is, how do they know that?

If it’s your first time venturing into the world of investments and stocks, it could be quite intimidating.

And even if it’s not your first time, investing in stocks can still be scary.

The very act of investing in stocks carries a certain risk after all. But, why invest in stocks when it’s all risk right?

Of course, there’s a reason why people still invest in stocks amidst the risk.

While you cannot be 100% certain and safe with your investments, there are certain metrics you can use to gauge their value.

These metrics can help investors in assessing whether a business is profitable, and can stay profitable.

For example, we have financial ratios that relate a business’s income to the prevailing market price of a stock.

In this article, we will be discussing one of the ratios that’s important for the business and its investors.

This ratio is what we refer to as Cash Flow Yield.

We will learn what this ratio is, what it tells us, and why it’s important.

Also, we will learn the formula used for its computation.

And while we’re at it, we might as well as do some exercises to familiarize ourselves with its computation.

Let’s get started!

What is Free Cash Flow?

You might have already heard the phrase “cash is king”.

There’s some truth to it.

Lots of business transactions involve the use of cash.

For example, when purchasing materials, the purchaser would need to pay cash in exchange for the materials.

Sure, the supplier might allow credit purchases, but the purchaser would eventually have to pay the supplier in cash.

Cash is important for any business.

Without it, the business won’t be able to pay its dues.

It won’t be able to pay the rent for the space it’s occupying.

It won’t be able to pay the salaries and wages of its employees.

More importantly, it won’t be able to pay its creditor which might urge them to seize its properties.

That’s why some businesses give more importance to cash.

Now that we’ve discussed the importance of cash for a business, let’s talk about cash flow.

Particularly, free cash flow.

Free cash flow is the net cash generated by a business’s operations after paying for its operating and capital expenses.

Operating expenses refer to expenses necessary for the operations of the business such as rent, payroll, taxes, etc.

Capital expenditures mainly refer to the acquisition of capital assets, but can also include substantial repairs and maintenance costs.

Essentially, free cash flow refers to the cash flow available for payment of debts and cash dividends.

The free cash flow of a business can be computed using the following formula:

Free Cash Flow = Net Operating Cash Flow – Capital Expenses

-or-

Free Cash Flow = Net Income + Non-cash Expenses – Increase (Decrease) in Working Capital – Capital Expenses

The first formula is used if you can apply the direct method in computing the operating cash flow.

Otherwise, the second formula is used (which involves the indirect method in computing the operating cash flow).

What is Free Cash Flow Yield (FCFY)?

Free cash flow yield (FCFY) is one of the financial ratios that measure a business’s solvency.

It compares a business’s free cash flow to the market value of its outstanding shares.

It could also be viewed as comparing the free cash flow per share to the market value per share.

Free cash flow yield (FCFY) is an important metric for any business as it can assess its operational efficiency to generate cash.

Or more specifically, cash that can be used to pay back its creditors (by paying debt) or investors (by distributing cash dividends).

Free cash flow yield (FCFY) helps in gauging the financial strength and health of a business.

Basically, the higher the FCFY of a business is, the better it is in generating cash flow.

A high FCFY can also mean that the business is self-sufficient enough that it can fund both its operating and capital expenses.

If a business’s FCFY is low or even negative, it may indicate that the business is having liquidity issues.

If a business is not liquid enough, it won’t be able to pay for its operating expenses.

And if it’s not remedied, it will lead to solvency issues, and ultimately, bankruptcy.

More importantly, if a business has negative FCFY, it might mean that it does not have enough cash to pay off its debts.

Much less distribute cash dividends.

This could potentially make the business a bad investment in the eyes of potential investors.

Why invest in a stock that can’t give you any returns right?

A low or negative FCFY does not always mean that the business is in trouble though.

It could mean that the business is prioritizing its investments in capital assets to facilitate growth.

This could be the case for new businesses or those that are expanding.

The Free Cash Flow Yield (FCFY) Formula

Free cash flow yield (FCFY) is pretty simple to compute.

You only need to gather two variables:

• a business’s free cash flow; and
• the market value of its outstanding shares (market capitalization).

Once you have your data, you just divide the free cash flow by the market capitalization.

Put into formula form, it would look like this:

FCFY = Free Cash Flow ÷ Market Capitalization

Where:

Free Cash Flow = Operating Cash Flow – Capital Expenses -or- Net Income + Non-cash Expenses – Increase (Decrease) in Working Capital – Capital Expenses

Market Capitalization = Market Value Per Share x Number of Outstanding Shares

There’s also a more conservative approach that uses the business’s enterprise value rather than its market capitalization.

It uses the business’s enterprise value in its formula as the denominator:

FCFY = Free Cash Flow ÷ Enterprise Value

Where:

Free Cash Flow = Operating Cash Flow – Capital Expenses -or- Net Income + Non-cash Expenses – Increase (Decrease) in Working Capital – Capital Expenses

Enterprise Value = Market Capitalization + Total Debt/Liabilities – Cash and Cash Equivalents

Both approaches are valid and can be used for determining a business’s FCFY. Using the market capitalization as the denominator is similar to computing a business’s Price-to-earnings Ratio.

Using the enterprise value as the denominator makes it possible to compare with other businesses regardless of industry.

Provided that they have similar capital structures that is.

Use whichever approach suits your needs.

Calculating Free Cash Flow Yield (FCFY)

To better understand the FCFY formula, let’s have some exercises.

Exercise#1

From Company A’s financial statements, the following data was gathered:

Let’s compute for company A’s FCFY by using the above data.

First, we gather company A’s free cash flow. The data above has given us company A’s operating cash flow and capital expenses. With these data, we compute the free cash flow:

Free Cash Flow = Operating Cash Flow – Capital Expenses

= $721,040 – $171,369

= $549,671

As per computation, company A’s free cash flow is $549,671.

Next, we compute for company A’s market capitalization. We multiply the market value per share by the number of outstanding shares:

Market Capitalization = Market Value Per Share x Number of Outstanding Shares

= $35 x 100,000

= $3,500,000

As per computation, company A’s market capitalization is $3,500,000.

Now that we have the figures for free cash flow and market capitalization, we can proceed with the computation of FCFY:

FCFY = Free Cash Flow ÷ Market Capitalization

= $549,671 ÷ $3,500,000

= 0.157 or 15.7%

As per computation, company A’s FCFY is 0.157 or 15.7%.

This figure can be interpreted in a lot of ways.

For example, let’s assume that company A does not have any debt (i.e. 100% equity-financed).

This means that it can distribute all of its free cash flow as dividends.

For every outstanding share, it can have a maximum of 15.7% free cash flow yield from the dividends alone.

Exercise#2

Suppose that we use Company A’s enterprise value instead.

In addition to the data from exercise#1, we gathered the following:

First, we compute for company A’s enterprise value:

Enterprise Value = Market Capitalization + Total Debt/Liabilities – Cash and Cash Equivalents

= $3,500,000 + $1,500,000 – $1,013,880

= $3,986,120.00

As per computation, company A’s enterprise value is $3,986,120.

Next, we proceed to the computation of FCFY, only this time, we will use company A’s enterprise value as the denominator:

FCFY  = Free Cash Flow ÷ Enterprise Value

= $549,671 ÷ $3,986,120

= 0.1379 or 13.79%

As per computation, company A’s FCFY using this approach is 0.1379 or 13.79%.

Did you notice that it is lower than our computed FCFY from exercise#1?

That is because company A’s total liabilities exceed its cash and cash equivalents.

Which made company A’s enterprise value greater than its market capitalization. As such, the FCFY is lower.

Exercise#3

Company B had a net income of $1,030,000.

The following data has been gathered regarding its non-cash expenses:

Company B’s working capital increased by $88,000 for the year.

It had capital expenses of $330,000.

The following data has also been gathered regarding its outstanding shares:

Let’s solve for company B’s FCFY using the data above.

First, we compute for company B’s free cash flow.

We will be using the indirect method of computing for the operating cash flow this time:

Free Cash Flow = Net Income + Non-cash Expenses – Increase (Decrease) in Working Capital – Capital Expenses

=$1,030,000 + ($270,000 + $130,000) – $88,000 – $330,000

= $1,012,000

As per computation, company B’s free cash flow is $1,012,000.

Next, we gather company B’s market capitalization:

Market Capitalization = Market Value Per Share x Number of Outstanding Shares

= $20 x 250,000

= $5,000,000

As per computation, company B’s market capitalization is $5,000,000.

Now that we have the figures for free cash flow and market capitalization, we can proceed with the computation of FCFY:

FCFY = Free Cash Flow ÷ Market Capitalization

= $1,012,000 ÷ $5,000,000

= .2024 or 20.24%

From our computation, we determine that company B’s FCFY is 20.24%.

Depending on the industry that company B belongs to, this can be interpreted as a good or bad FCFY.

But as long as it isn’t in the negative, company B will be able to self-finance its operating and capital expenses.

Importance of Free Cash Flow Yield (FCFY) from a business’s perspective

Free cash flow yield is an important metric for internal and external parties alike.

From a business owner’s perspective, FCFY is an indicator of the business’s capability to be self-sufficient.

By that, I mean that the business can finance its operating and capital expenses just from its cash flow alone.

This is beneficial for the business as seeking external funding is oftentimes more costly than self-financing.

That means that if a business can self-finance its expenses, it won’t have to incur additional expenses brought along by external funding.

A high FCFY also means that the business is liquid, and most probably solvent too.

This means that it won’t have trouble paying its current expenses and liability.

Not only that, but it can also declare and distribute dividends without having to compromise its sustainability.

This makes the business an attractive investment for potential investors and creditors.

Whereas, if a business has constantly low or negative FCFY, it might indicate that the business is having liquidity issues.

Not being to pay current expenses and liabilities will affect the business’s credibility.

If not addressed immediately, it might lead to the closure of the business.

Importance of Free Cash Flow Yield (FCFY) from an investor’s perspective

Free cash flow yield (FCFY) is one of the metrics that gauge whether an investment is worth it or not.

Basically, if a stock has a high FCFY, the probability of it giving you a high return is also high.

This is why stocks with high FCFY are more attractive than their counterparts that have low FCFY.

A higher FCFY means higher dividends after all.

But a low or negative FCFY doesn’t necessarily mean that the business is on the verge of insolvency.

It could mean that the business is investing more in capital assets to facilitate growth.

So if you’re an investor who’s in it for growth rather than short-term returns, FCFY may not be that much of value for you.

You might want to rely on other metrics instead such as Price-to-Earnings ratio, and other profitability ratios.

Nevertheless, FCFY is just one of the metrics that can assess a stock’s value.

While it is helpful on its own, using it in conjunction with other metrics will be of more benefit.

For example, you might want to pair it with the business’s Price-to-Earnings ratio.

This will give you a broader view of the business’s financial performance and health.