What is the Free Cash Flow Yield?
The free cash flow yield is a valuation ratio that compares a company’s current share price earnings with its free cash flow per share. It is the inverse of the price-free cash flow (P/FCF) ratio.
How to Calculate the Free Cash Flow Yield
The free cash flow yield can be calculated in two ways.
The first way is to divide 1 by the P/FCF ratio.
The second way is to divide the free cash flow per share by the current share price.
How to Interpret the Free Cash Flow Yield
A high free cash flow yield such as 20% suggests that shares are cheap, since the company’s share price is low compared to the free cash flow. This corresponds to a low P/FCF ratio of 5.
A low free cash flow yield, for example 1%, which corresponds to a P/E ratio of 100, suggests that shares are expensive.
Limitations of the Free Cash Flow Yield
Using the free cash flow yield as a relative valuation measure has its limitations, which need to be considered when evaluating whether a company’s shares are cheap or not.
1. A company must have positive free cash flow.
If a company shows negative free cash flow, the free cash flow yield is not useful. This makes the free cash flow yield more useful for established, more mature businesses that achieve report positive free cash flow, and not as useful for younger companies that are more likely to show negative free cash flow. For younger companies, the price-sales (P/S) ratio is more useful as a relative valuation measure.
2. The free cash flow yield may be overstating cheapness.
While a high free cash flow yield suggests that a stock is cheap, it is not necessarily a reason to buy the stock. The market might be factoring in expectations of future poor performance of the stock, justifying the low price. On the other hand, the stock might actually be cheap due to mispricing of the market.
3. The free cash flow yield may be understating cheapness.
A company with a low free cash flow yield suggests that the stock is expensive. A company might achieve low earnings by investing heavily into expenses that build out an economic moat to ensure profitability in the future, possibly justifying the higher price.
For these reasons, a more suitable measure would be the PEG ratio, which factors in not only the P/E ratio, but the earnings growth rate.