Cash Flow is King
Discuss what free cashflow yield means and why it is important
Some of you might remember Popeye’s friend, Wimpy who loves hamburgers but not pays for them.
“I’ll gladly pay you Tuesday for a hamburger today.”
In this current volatile investment environment, you hear advocates of “cash is king”. Nothing beats real cash on hand.
In the investment world, cash flow, especially free cash flow is an important concept to understand a company’s stability and capital strength.
The Power of Free Cash Flow
Free cash flow is the money that is left after a company pays its expenses, taxes, interests, and long-term capital expenditure. Dividends, debt payments, stock buybacks, and growth investments will come from free cash flow.
When a company earns a positive free cash flow, it generates more cash than it needs to operate its business and can invest to grow.
Free cash flow (FCF) = Operating cash flow minus capital expenditure
Both the operating cash flow and capital expenditure can be found in a company’s cash flow statement.
Free cash flow is not net income because net income does not measure the true cash of a company. For example, if a company increases revenue in the form of accounts receivable to be collected next year, the company has not received the cash yet. So an increase in accounts receivables will subtract from cash flow even though revenue is reported in the net income number.
Free cash flow (FCF) is therefore a better number than net income to measure a company’s performance and how much cash is available to distribute to shareholders.
Companies can manipulate their earnings but cannot mess around with free cash flow.
What is Free Cash Flow Yield?
It is calculated by comparing a company’s free cash flow per share to its market value per share.
Free cash flow yield (FCFY) = Free Cash Flow per Share/Price per Share
The higher the free cash flow yield, the more valuable the company is because of its stronger ability to pay off debt, distribute cash to shareholders, and invest for its own benefit.
Warren Buffett likes to look at cash flow rather than earnings multiples to determine if an investment is cheap or not.
I wouldn’t look for a single metric like relative P/Es to determine what — how — to invest money. You really want to look for things you understand, and where you think you can see out for a good many years, in a general way, as to the cash that can be generated from the business. And then, if you can buy it at a cheap enough price compared to that cash, it doesn’t make any difference what the name attached to the cash is.~Warren Buffett
What to Look For?
You have probably heard that “value” stocks have been doing better than the “growth” stocks this year.
Rather than looking for a value or growth stock, a better way to screen investment is to look at the free cash flow yield to understand the business strength of the company compared to its market value.
The above chart shows the free cash flow yield of the 11 GICs sectors in the S&P 500 Index.
The Financials and Energy sectors have the highest free cash flow yield, and these sectors are often included in the “value” segment of the market. In a risk-off environment, investors care for quality and cash flow.
A persistent negative free cash flow may signify a company is becoming illiquid and cannot sustain its operations.
A negative free cash flow yield is not always bad. If the company is investing for the future and is expecting a higher investment return than the cash paid, like in a high-growth company, the temporary negative free cash flow yield needs to be investigated against the company’s business needs and potential.
We have to avoid the Wimpys of the world.
The original article appeared on Medium.
This article is for informational purposes only. It should not be considered financial or legal advice. Not all information will be accurate. Consult a financial professional before making major financial decisions.
I started my buy-side investment career in the mid-1990s as a fixed income analyst in an international mutual fund company right after MBA graduation and became a Chartered Financial Analyst. Since then I have been a keen student of the market.
Check out my other One Chart One Idea stories.
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Greta take, thank you!
FCF with stock based compensation treated as a cash charge or non-cash as an expense item? ;)