Smarter Investing With The Free Cash Flow Yield:
How To Capture The Strongest, Most Fundamentally Undervalued Companies, Using The "Free Cash Flow Yield", By Shiraz Lakhi.
Many 'technical' traders don't keep tabs on the 'fundamental' values within the stocks they are trading. That's a mistake. By taking into account the basic operational nuts and bolts of a business, using some simple, finely tuned metrics, investors are in a much better position to spot trouble early. Better yet, this common-sense, five minute process will improve the odds of finding the 'undervalued' home-run stocks that provide the best returns.
Whenever I look for a company to invest in, I make it a rule to initially focus only on the operating 'fundamentals' of a business. One of the key metrics I utilize, is the 'free cash flow yield'. The process begins by screening an initial universe of around 1,500 US stocks, listed on the NYSE, Nasdaq, and Amex, in order to isolate only those companies with a minimum market-cap of $30m, positive operating income (loss making businesses are removed), and a minimum free-cash-flow-yield of 10%.
This initial step narrows down the original universe of 1,500 stocks, to around 40-60 companies I can focus on...
At this point, 'financial' stocks are removed, as are coal stocks, gold/silver mining companies, and biotechnology stocks. Remaining companies are systematically analyzed, starting with a health check on key 'growth' metrics (positive year-on-year 'revenue' growth, operating 'income' growth, and most critically operating 'margin' growth), and leverage ratios (long-term-debt/equity ratio and short-term-assets/short-term-liabilities, also known as current ratio). Qualifying companies based on these added filters demonstrate strong, competent management, both in terms of performance (growth) and efficiency (healthy or zero leverage).
Central to the strategy, as indicated above, is the minimum 10% free-cash-flow-yield qualifier. The free-cash-flow-yield is calculated by dividing the companies 'free-cash-flow' figure by the 'enterprise-value'. Both metrics are readily available, for most all positive earning US stocks, via Google Finance and Yahoo Finance, under ‘key statistics’ (click here for an example)…
Effectively, the enterprise-value metric allows investors to see the ‘real’ worth of the business (taking into account both debt and cash). While the EV provides a valuable indicator of the true ‘worth’ of a business, the free-cash-flow (FCF) provides an indication of the true ‘earnings’ power of the business. The FCF is a superior, more accurate reflection of a company’s ability to generate cash (profits), than the commonly presented ‘net earnings’ or EPS data regularly reported within the media…
Relying only on the much touted ‘earnings’ data carries unnecessary risk for naive investors. Earnings can often be subject to questionable accounting tactics (managements need to impress can overshadow true essence), which can obscure the true reflection of operational performance, for instance, tactical accountancy can carry forward (and backwards) ‘non-operational’ and ‘one-off’ entries, which results in information which cannot accurately reflect the core operational performance (on a consistent, sustainable, year-on-year context) of the business...
When I am looking for companies to invest in, I favor the free-cash-flow, or operating-income, or earnings-before-interest-and-tax (also known as EBIT) metrics, as opposed to the populus (and often misguided) 'net-earnings' metric. Of these the best reflection (in my opinion) of a companies ability to generate cash (profits), is via the free-cash-flow metric, also published for any stock, via Yahoo Finance, under ‘key statistics’...
Armed with the FCF value and the EV value, an investor can therefore instantly, and accurately, measure the ‘percentage yield’ a company generates, by dividing the free-cash-flow (FCF), by the enterprise-value (EV), and multiplying the result by 100 to arrive at a percentage. If the FCF is $30m and EV is $300m, then the free-cash-flow-yield is 10% (FCF/EV).
Looking at this in simple terms, assume you are in the market to buy an ongoing business. You look at business “A” for which the owner wants to be paid $70,000 (the ‘price’). On it’s books, the company owes money, to the tune of $40,000 (the ‘debt). On the plus side, the company also holds some cash reserve of $15,000 (the ‘cash’). You do a quick calculation, and see that, in order to acquire the business, you would need to pay the owner his $70,000, add to this the debt which you are taking on, amounting to $40,000, and keep the cash already on the books, totaling $15,000. Therefore, the total ‘true’ cost to acquire the business, better known as the ‘enterprise-value’ is $95,000 (that is $70,000 price ‘plus’ $40,000 debt ‘minus’ $15,000 cash)…
Next, you study the companies accounts and see the pure, free-cash-flow generated in the business, which amounts to $18,000. From this data, you see that, for company “A”, the FCF/EV ratio is 0.1894 ($18,000/$95,000). In other words the true percentage ‘yield’ (the free-cash-flow-yield) is 18.94%. All things equal, for your investment of $95,000, you can expect an 18.94% return, without applying any further changes.
You look at another business, company “B” for which the owner wants to be paid $110,000 (the ‘price’), plus the debt which the business owes, to the tune of $75,000 (the ‘debt’). In it’s books, the company also holds some cash reserve of $12,000 (the ‘cash’). So again, you do the simple math, to see if company “B” offers better value, and a better proposition from an investment standpoint. You see that, in order to acquire the business, you would pay the current owner her $110,000, add the debt which you are taking on, amounting to $75,000, and keep the cash already on the books, totaling $12,000. The net cost to acquire the business (the ‘enterprise-value’) is therefore $173,000 (that is $110,000 price ‘plus’ $75,000 debt ‘minus’ $12,000 cash).
Once again, you look at the company accounts and see the pure, free-cash-flow generated in the business, which amounts to $37,000. From this data, you see that, for company “B”, the FCF/EV ratio is 0.2138 ($37,000/$173,000). In other words the true percentage ‘yield’ (the free-cash-flow-yield) is 21.38%. For your investment of $173,000, you can expect a 21.38% return.
Based purely on these metrics (subject to further analysis and due diligence, primarily ensuring the business exists within a 'growth' market), it is immediately apparent that company “B” is more ‘undervalued’ than company “A”, and hence company “B” offers a better ‘value’ (yield) investment opportunity. Effectively, the free-cash-flow-yield removes much of the ‘hidden-surprises’ defect inherent in the P/E ratio (which is based on the flawed 'net-income' or 'earnings-per-share' metric, and provides a more transparent, mature measurement, from which individuals and corporations can more accurately evaluate equity investments…
To summarize, no matter which method investors utilize towards seeking out potential stock investment opportunities, be it technical analysis, fundamentals, or a 'mix' of the two, it is a good idea to get back to the basics, the 'nuts and bolts' of the operational performance (free-cash-flow over the past 12 months), relative to the true worth (enterprise-value), of a business, as expressed by the simple-to-calculate, and demonstrated free-cash-flow-yield.
Investing in a company, whether short, medium or long term, is no different to buying a business, which is effectively, exactly what you are doing. As an investor, you need to know what profits are being generated from the 'operation' of the core business. This allows you to work out the free-cash-flow-yield (by dividing the free-cash-flow by the enterprise-value, and multiplying the result by 100). Each industry, comprising of competing, profitable businesses, operate within similar fields. When comparing two businesses (within the same industry), a good benchmark measure of management competence and market undervalue, can be generated effectively, using the free-cash-flow-yield.
Wishing you every success in your trading... and good spirit...
Shiraz Lakhi - Self Directed Trader/Publisher
About the author: Shiraz Lakhi is an independent investor, speculator, entrepreneur, and founder of free stock screening site tradepilot.com.
Investors can follow Shiraz Lakhi's trade ideas, regularly posted live on stocktwits.com/tradepilot, and at shirazlakhi.com. All information, and educational articles are disseminated completely free, in an effort to help like-minded individuals - self-directed investors & traders - gain valued knowledge based on experience. Educational articles, based on the free cash flow yield metric, are regularly submitted by Shiraz Lakhi at Seeking Alpha, including stock specific (long stock/short S&P) trade ideas.