Investors use many valuation metrics while screening stocks for possible investments. This includes valuation ratios such as Price to Earnings ratio, price to book value, price to sales, price to cash flow and many others. While all these valuations metrics are good, one that has been attracting many investors is the Free Cash Flow Yield. In this article we will look at why free Cash Flow Yield is a good measure and we will also build a Free Cash Flow Yield Screener on S&P500 stocks using MarketXLS.
What is Free Cash Flow?
Free cash flow (FCF) refers to the cash generated by the firm’s operation that is available to shareholders after the company has paid for all its expenses.
Free Cash Flow = Cash Flow from Operations – Net Capital Expenditure
This includes having paid for o laying out cash for expenses, taxes, interest as well as long-term investments.
The company can use free cash flow for many purposes such as for developing new products, buy-back shares, issue dividends, or make acquisitions. Without free cash flow, the company will have to borrow to pay for these things.
A positive free cash flow indicates that the company is generating more cash flow than what is required to run the business which allows it to pursue other growth opportunities.
What is Free Cash Flow Yield?
Once we have the free cash flow, we can calculate the free cash flow yield by dividing free cash flow with the enterprise value.
Free Cash Flow Yield = Free cash FLow / Enterprise Value
The Enterprise Value is equal to the firm’s Market Capitalization + Debt – Cash.
A higher free cash flow yield means that the company generates more cash with the same market valuation which is good for investors. It is a good indicator to determine the investor’s payback period. The higher the free cash flow yield, the lower will be the investor payback period. For example, if the yield is 1%, the payback period will be 100 years. However with a yield of 5 years, the investor payback period will reduce to just 20 years.
Why investors like Free Cash Flow Yield?
There are many reasons why investors prefer Free Cash Flow yield over other valuation metrics:
- Strong balance sheet and cash flow generation capability
- The company is generating more cash flow than it needs to spend, thereby less dependency on external funding
- Free cash flow is a more reliable indicator of the firm’s profitability compared to its earnings. This is because free cash flow is more difficult to manipulate than the net income.
- It is based on market value, not book value of the firm.
- Negative free cash flow also is not bad. If a company has negative free cash flow it might mean that the company is making larger investments.
Free Cash Flow Yield Screener
In order to identify and invest in high free cash flow yield, investors can use a screener based on free cash flow yield. There are many ways to do it. One is to take all the S&P500 stocks, calculate their Free Cash Flow Yield and either pick the top 10-20 stocks or take stocks having a yield above certain percentage (suhas >10% yield). You can also combine other metrics such as dividend yield to further shortlist the stocks. For example you can use high free cash flow yield to screen for sustainable dividend yield. This combination indicates continuous income stream along with long-term capital appreciation.
Free Cash Flow Yield Screener for S&P500 in Excel using MarketXLS
We have created a Free Cash Flow Yield screener template that downloads the latest list of the S&P500 stocks, calculates the Free Cash Flow Yield for each stock and then filters the stocks with the top yield. The yield is calculated using the MarketXLS historical fundamentals functions. You will need a licensed copy of MarketXLS to use the template.