Smarter Investing With The Free Cash Flow Yield:

How To Capture The Strongest, Most Fundamentally Undervalued Companies, Using The "Free-Cash-Flow" Metric, 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 account of fundamentals, using some simple, finely tuned metrics, you're in a much better position to spot trouble early. Better yet, you'll improve your odds of finding the 'undervalued' home-run stocks that provide the best returns.

A constructive, common-sense approach would be to maintain a 'watch-list' of the strongest, most fundamentally undervalued stocks (based on the criteria described below), to which technical analysis can be applied to better 'time' entries. This way, investors, can reconcile both schools of thought (fundamental and technical) towards a productive trading plan.

Whenever I look for a company to invest in, I make it a rule to initially focus only on 'fundamentals', more specifically, the financial 'cash-flow' metrics of the business. The process begins by screening an initial universe of around 1,500 US stocks, listed on the NYSE, Nasdaq, or Amex, in order to isolate only those companies with a minimum market-cap of $50m, positive profit (loss making businesses are removed), and a minimum free-cash-flow-yield of 10%. This initial step quickly narrows down the original universe of 1,500 stocks, to around 30-40 companies I focus on...

At this point, 'financial' stocks are removed, and each remaining company is systematically analyzed, by calculating the 'free-cash-flow-to-enterprise-value' ratio (the 'free-cash-flow-yield'). These two items of data are at the core of my fundamental analysis. Both the 'free-cash-flow' and 'enterprise value" data points are readily available for most all US stocks, via Yahoo Finance, under 'key statistics' (click here for an example snapshot)...

The enterprise-value (EV) is a more accurate version of the commonly used 'market-cap'. EV measures the true value of a company, from the perspective of a potential buyer of the business. By taking the market capitalization value of a business, then adding the debt, and subtracting the total cash, you get a more exact reflection of what the business is genuinely 'worth', and more crucially, what a potential buyer would consider paying to acquire the business. Think about this. A potential buyer of the company would not pay the market cap, but would have to also pay for any debt the company has outstanding, minus keeping any cash.

So, the enterprise-value allows investors to see the 'real' worth of the business. We will come back to this in a moment...

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 more superior, accurate reflection of a company's ability to generate cash (profits), than the commonly presented 'earnings' data regularly reported within the financial press/media...

Relying only on the much touted 'earnings' data carries considerable added risk for investors. Earnings can often be subject to questionable accounting tactics, which can obscure the true reflection of 'operational' performance, for instance, tactical accountancy can carry forward (and backwards) figures which results in vague information. A more recent version, known as EBITDA (Earnings before Interest, Tax, Depreciation & Amortization) has become a popular metric, aimed at replacing the over-simplistic 'earnings' data, but again, the EBITDA also contains a number of noted flaws and does not remove the potential risk of questionable accounting tactics...

This is why, the only true, unadulterated, reflection of a companies ability to generate cash (profits), is via the free-cash-flow metric. The 'free-cash-flow' figure is also readily available for any US listed stock, via Yahoo Finance, under 'key statistics'.

Armed with the FCF value and the EV value, an investor can quickly, and accurately measure the 'percentage yield' a company generates, by dividing the free-cash-flow (FCF), by the enterprise-value (EV)...

Looking at this in more simple terms, assume you are in the market to buy a running 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')...

So, 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 is 0.1894 ($18,000/$95,000). In other words the true percentage 'yield' (or the free-cash-flow-yield) is precisely 18.94%. All things equal, for your investment of $95,000, you can expect an 18.94% return.

Another example. 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 same simple math, to see if company "B" offers better value...

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 $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' (or 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 (always subject to further analysis and due diligence), company "B" looks to offer a better value investment opportunity (more 'undervalued', by offering a higher 'yield') than company "A".

The free-cash-flow-yield removes much of the defects inherent in the P/E ratio, and provides a more transparent, mature measurement, from which individuals can more accurately evaluate equity investments. Moreover, the 'comparisons' of free-cash-flow-yield between various competing businesses within the same industry, provide an excellent starting point for potential investing ideas when you are looking to 'pick' specific stocks within a specific industry or sector.

Added to this, investors can implement a fully hedged long stock/short S&P hedged pairs trading strategy which wagers on the undervalued stock outperforming the S&P index without anxiety about market direction.

To summarize, no matter which method, you 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, relative to the true worth, of a business, as expressed by the simple-to-calculate, and demonstrated free-cash-flow-yield metric.

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. If the business generates $50m, then the enterprise-value would generally be around $800m (yield=6.25%)...

If the current enterprise-value in the business is actually $500m, then you know instantly that the company is probably 'undervalued' (yield=10%). If on the other hand, the current enterprise-value in the business is $1.2 Billion, then you know that the company is probably 'overvalued' (yield=4.16%). These simple metrics, more often than not, are the very starting point for evaluating potential mergers & acquisitions.

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.

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