What Is Free Cash Flow Yield?
Free cash flow yield is a financial solvency ratio that compares the free cash flow per share a company is expected to earn against its market value per share. The ratio is calculated by taking the free cash flow per share divided by the current share price. Free cash flow yield is similar in nature to the earnings yield metric, which is usually meant to measure GAAP (generally accepted accounting principles) earnings per share divided by share price.
The Formula for Free Cash Flow Yield is:
FreeCashFlowYield=MarketPriceperShareFreeCashFlowperShare
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What Does theFree Cash Flow YieldReveal?
Generally, the lower the ratio, the less attractive a company is as an investment, because it means investors are putting money into the company but not receiving a very good return in exchange. A high free cash flow yield result means a company is generating enough cash to easily satisfy its debt and other obligations, including dividend payouts.
Some investors regard free cash flow, which excludes capital expenditures but considers other ongoing costs a business incurs to keep itself running, as a more accurate representation of the returns shareholders receive from owning a business. They prefer to use free cash flow yield as a valuation metric over an earnings yield.
In addition to sustaining ongoing operations, cash flow from operations is also a funding source for a company's long-term capital investments. Before tapping into any outside financing, a company first uses its operating cash flow to meet capital expenditure requirements. Anything left is referred to as free cash flow and becomes available to equity holders.
For investors preferring cash flow yield as a valuation metric over valuation multiples, the free cash flow yield would be a more accurate representation of investment returns, compared to yields based on cash flow not fully returnable or accounting earnings.
Key Takeaways
- A higher free cash flow yield is ideal because it means a company has enough cash flow to satisfy all of its obligations.
- If the free cash flow yield is low, it means investors aren't receiving a very good return on the money they're investing in the company.
- The free cash flow yield gives investors an idea of how financially capable a company is at having quick access to cash in case of unexpected debts or other obligations, or how much cash would be available if the company had to be liquidated.
The Difference Between Cash Flow and Earnings
Free cash flow derives from operating cash flow, which is the net result of actual cash received and paid during a company's operations. Using cash flow to measure operating results is different from accounting-based earnings reporting. Earnings track every element of revenue and expense, regardless of cash involvements.
While earnings in principle summarize a company's total net income on account, cash flow concerns a company's ability to sustain its ongoing operations. The more cash a company amasses from operations, the easier it is to continue carrying out its business and to ultimately generate more earnings. The ability to yield cash flow can be a better indication of a company's longer-term valuation.
Cash Flow Yield Versus a Valuation Multiple
Investors may evaluate a company's worth by comparing its cash flows (business return) with its equity value. Cash flow can be a proper return representation, and market price a close proxy of equity value. Investors may judge a company's worth based on the percentage of its cash flow over the equity's market price, which is referred to as cash flow yield.
Alternatively, investors may look at a company's worth using a valuation multiple calculated as its equity's market price over the amount of cash flow. Evaluating an investment using cash flow yield can be more intuitive than a valuation multiple, as cash flow yield directly shows the cash returned as a percentage of the investment.
