By Hans Wagner
Most investors are familiar with fundamental indicators such as the price-earnings ratio (P/E), bookvalue, price-to-book (P/B) and the PEG ratio. Investors, who recognize the importance of cash generation, use the company's cash flow statements when analyzing its fundamentals. They recognize these statements offer a better representation of the company's operation. However, very few people look at how much free cash flow is available compared to the value of the company. Think of this as free cash flow yield, and a better indicator than the P/E ratio. (For a primer and overview of the cash flow statement, refer to What Is A Cash Flow Statement?)
Free Cash Flow
Most investors are familiar with fundamental indicators such as the price-earnings ratio (P/E), bookvalue, price-to-book (P/B) and the PEG ratio. Investors, who recognize the importance of cash generation, use the company's cash flow statements when analyzing its fundamentals. They recognize these statements offer a better representation of the company's operation. However, very few people look at how much free cash flow is available compared to the value of the company. Think of this as free cash flow yield, and a better indicator than the P/E ratio. (For a primer and overview of the cash flow statement, refer to What Is A Cash Flow Statement?)
Free Cash Flow
Cash in the bank is what every company strives to achieve. Investors are
interested in what cash the company has in its bank accounts, as these
numbers show the truth of a company's performance. It is more difficult
to hide financial misdeeds and management adjustments in the cash flow
statement.
Cash flow is the measure of cash into and out of a company's bank
accounts. Free cash flow, a subset of cash flow, is the amount of cash
left over after the company has paid all its expenses and what was spent
for capital expenditures (reinvested
into the company). You can quickly calculate the free cash flow of a
company from the cash flow statement. Start with the total from the cash
generated from operations. Next, find the amount for capital
expenditures in the cash flow from investing section. Then subtract the
capital expenditures number from the total cash generated from
operations to derive free cash flow.
When free cash flow is positive, it indicates the company is generating
more cash than is used to run the company and reinvest to grow the
business. A negative free cash flow number indicates the company is not
able to generate sufficient cash to support the business. Many small
businesses do not have positive free cash flow as they are investing
heavily to rapidly grow their business.
Free cash flow is similar to earnings for a company without the more
arbitrary adjustments made in the income statement. As a result, you can
use free cash flow to help measure the performance of a company in a
similar way to looking at the net income line. This raises the question,
is there a similar measure to the price earnings ratio (P/E Ratio) for
free cash flow? The P/E ratio measures how much annual net income is
available per common share. The P/E ratio is widely published and used
by investors to evaluate the value of a company. However, the cash flow
statement is a better measure of the performance of a company than the
income statement. Is there a comparable measurement tool to the P/E
ratio that uses the cash flow statement? (For a complete list and
discussion of all the major ratios in financial analysis, be sure to
check out our Financial Ratios Tutorial)
Free Cash Flow Yield
We can use the free cash flow number and divide it by the value of the company as a more reliable indicator. Called the free cash flow yield, this gives investors another way to assess the value of a company that is comparable to the P/E ratio. Since this measure uses free cash flow, the free cash flow yield provides a better measure of a company's performance.
We can use the free cash flow number and divide it by the value of the company as a more reliable indicator. Called the free cash flow yield, this gives investors another way to assess the value of a company that is comparable to the P/E ratio. Since this measure uses free cash flow, the free cash flow yield provides a better measure of a company's performance.
The most common way to calculate free cash flow yield is to use market capitalization as the divisor. Market capitalization is widely available, making it easy to determine. The formula is:
| Free Cash Flow Yield = Free Cash Flow Market Capitalization |
Another way to calculate free cash flow yield is to use enterprise value as
the divisor. To many, enterprise value is a more accurate measure of
the value of a firm, as it includes the debt, value of preferred shares
and minority interest, but minus cash and cash equivalents. The formula
is:
| Free Cash Flow Yield = Free Cash Flow Enterprise Value |
Both methods are valuable tools for investors. Use of market
capitalization is comparable to the P/E ratio. Enterprise value provides
a way to compare companies across different industries and companies
with various capital structures.
To make the comparison to the P/E ratio easier, some investors invert
the free cash flow yield, creating a ratio of either market
capitalization or enterprise value to free cash flow.
As an example, the table below shows the free cash flow yield for four large cap companies and their P/E ratios in the middle of 2009. Apple (Nasdaq:AAPL) sported a high trailing P/E ratio, thanks to the company's high growth expectations. General Electric (NYSE:GE)
had a trailing P/E ratio that reflected a slower growth scenario.
Comparing Apple's and GE's free cash flow yield using market
capitalization indicated that GE offered more attractive potential at
this time. The primary reason for this difference was the large amount
of debt that GE carried on its books, primarily from its financial unit.
Apple was essentially debt-free. When you substitute market
capitalization with the enterprise value as the divisor, Apple becomes a
better choice.
Comparing the four companies listed below indicates that Cisco is
positioned to perform well with the highest free cash flow yield, based
on enterprise value. Lastly, although Fluor had a low P/E ratio, it did
look as attractive after taking into consideration its low FCF yield.
 |
The Bottom Line
Free cash flow yield offers investors a better measure of a company's fundamental performance than the widely used P/E ratio. Investors who wish to employ the best fundamental indicator should add free cash flow yield to their repertoire of financial measures. Like any indicator, you should not depend on just one measure. However, it is appropriate to employ measures that give you a fair picture of the fundamental performance of the company you are considering. Free cash flow yield is one such measure.
Free cash flow yield offers investors a better measure of a company's fundamental performance than the widely used P/E ratio. Investors who wish to employ the best fundamental indicator should add free cash flow yield to their repertoire of financial measures. Like any indicator, you should not depend on just one measure. However, it is appropriate to employ measures that give you a fair picture of the fundamental performance of the company you are considering. Free cash flow yield is one such measure.
For additional related reading, check out Analyze Cash Flow The Easy Way and Free Cash Flow: Free,But Not Always Easy.
http://www.investopedia.com/articles/fundamental-analysis/09/free-cash-flow-yield.asp
Disclaimer : The article published is for self-education purpose only.
