Calculation
Free cash flow yield compares the ratio of free cash flow per share to current share price. The general idea is that the higher the ratio, the cheaper the stock.
Another way of getting to the same result is to divide the annual free cash flow by the market capitalization.
Also, the free cash flow yield is the reverse of the price to free cash flow ratio. For instance, a P/FCF ratio of 15 translates to a free cash flow yield of 1/15, or 6.7%.
| P/FCF | FCF Yield |
|---|---|
| 5 | 20% |
| 10 | 10% |
| 15 | 6.7% |
| 20 | 5% |
| 30 | 3.3% |
| 50 | 2% |
| 100 | 1% |
As an example, let’s look at Waters Corporation (WAT), a producer of analytical chemistry consumables and instrumentation. Summing up the free cash flows of the last four quarters, or trailing twelve months (TTM), results in a total free cash flow of $626.16 million. With 61.36 million basic shares outstanding, this comes to a free cash flow of $10.20/share. Dividing this number by today’s (January 09, 2022) share price of $347.03, the free cash flow yield is 2.96%.
What is Free Cash Flow Yield?
Free cash flow yield is a relative valuation measure for how cheap or expensive a company’s stock is, and an indicator for a company’s ability to generate excess cash.
Moreover, it is a metric often mentioned by Bill Miller in interviews as a key factor for him to get excited about a stock.
How to Interpret Free Cash Flow Yield
By itself, a company’s current free cash flow yield doesn’t mean much, so we need to compare it to something. Three approaches can be used:
- Comparison of free cash flow yield to average market yield
- Comparison to historic free cash flow yields
- Comparison to competitors’ free cash flow yields
1. Comparison to Average Market Yield
First, we can compare the current free cash flow yield to the S&P 500 free cash flow yield. According to Distillate Capital’s report Asset Class Valuations in a Historical Context, the S&P 500 trailing free cash flow yield in 2020 was in the 3.5-4.5% range. Thus, Waters Corporation’s current free cash flow yield of 2.96% is slightly below, and therefore appears more expensive than the overall market.
2. Comparison to historic yields
We can also compare the current free cash flow yield to historic values. Looking at Waters Corporation’s historic numbers for the past 10 years, we can see that the current yield of 2.96% is rather low, suggesting that the current share price might be overpriced.
3. Comparison to competitor yields
A third way to interpret a company’s current free cash flow yield is to compare it to that of competitors. In the case of Waters Corporation, we can see that it is on par with Agilent Technologies (A), and lower, and therefore possibly more expensive, than Thermo Fisher Scientific (TMO), Danaher (DHR) and Avantor (AVTR).
Advantages of Free Cash Flow Yield
- Relatively easy to calculate
- Quick way to compare the cheapness of stock prices
- Cash flows cannot be manipulated as easily as earnings
Limitations of Free Cash Flow Yield
A low free cash flow yield doesn’t necessarily mean that a company’s stock is expensive. We have to keep a few things in mind:
- Free cash flow yield alone is not sufficient to estimate whether a company’s stock is cheap, fairly priced, or expensive. Other relative valuation metrics such as the P/E, P/S and P/B ratios should be evaluated as well, if appropriate.
- Free cash flow yield doesn’t tell us anything about the intrinsic value of the business. For a comprehensive valuation, this intrinsic value should be estimated with a discounted cash flow (DCF) analysis.
- A negative free cash flow yield doesn’t allow us to compare companies.
Further Study
The Investor’s Podcast Episode 117, Interview with Bill Miller.
