Most investors are familiar with fundamental indicators such as the price-earnings ratio (P/E), book value, price-to-book (P/B) and the PEG ratio. Investors, who recognize the importance of cash generation, use the company's cash flow statements when analyzing its fundamentals. They recognize these statements offer a better representation of the company's operation. However, very few people look at how much free cash flow is available compared to the value of the company. Think of this as free cash flow yield, and a better indicator than the P/E ratio. (For a primer and overview of the cash flow statement, refer to What Is A Cash Flow Statement?)

Free Cash Flow
Cash in the bank is what every company strives to achieve. Investors are interested in what cash the company has in its bank accounts, as these numbers show the truth of a company's performance. It is more difficult to hide financial misdeeds and management adjustments in the cash flow statement.

Cash flow is the measure of cash into and out of a company's bank accounts. Free cash flow, a subset of cash flow, is the amount of cash left over after the company has paid all its expenses and what was spent for capital expenditures (reinvested into the company). You can quickly calculate the free cash flow of a company from the cash flow statement. Start with the total from the cash generated from operations. Next, find the amount for capital expenditures in the cash flow from investing section. Then subtract the capital expenditures number from the total cash generated from operations to derive free cash flow.

When free cash flow is positive, it indicates the company is generating more cash than is used to run the company and reinvest to grow the business. A negative free cash flow number indicates the company is not able to generate sufficient cash to support the business. Many small businesses do not have positive free cash flow as they are investing heavily to rapidly grow their business.

Free cash flow is similar to earnings for a company without the more arbitrary adjustments made in the income statement. As a result, you can use free cash flow to help measure the performance of a company in a similar way to looking at the net income line. This raises the question, is there a similar measure to the price earnings ratio (P/E Ratio) for free cash flow? The P/E ratio measures how much annual net income is available per common share. The P/E ratio is widely published and used by investors to evaluate the value of a company. However, the cash flow statement is a better measure of the performance of a company than the income statement. Is there a comparable measurement tool to the P/E ratio that uses the cash flow statement? (For a complete list and discussion of all the major ratios in financial analysis, be sure to check out our Financial Ratios Tutorial)

Free Cash Flow Yield
We can use the free cash flow number and divide it by the value of the company as a more reliable indicator. Called the free cash flow yield, this gives investors another way to assess the value of a company that is comparable to the P/E ratio. Since this measure uses free cash flow, the free cash flow yield provides a better measure of a company's performance.

The most common way to calculate free cash flow yield is to use market capitalization as the divisor. Market capitalization is widely available, making it easy to determine. The formula is:

Free Cash Flow Yield = Free Cash Flow
Market Capitalization

Another way to calculate free cash flow yield is to use enterprise value as the divisor. To many, enterprise value is a more accurate measure of the value of a firm, as it includes the debt, value of preferred shares and minority interest, but minus cash and cash equivalents. The formula is:

Free Cash Flow Yield = Free Cash Flow
Enterprise Value

Both methods are valuable tools for investors. Use of market capitalization is comparable to the P/E ratio. Enterprise value provides a way to compare companies across different industries and companies with various capital structures. To make the comparison to the P/E ratio easier, some investors invert the free cash flow yield, creating a ratio of either market capitalization or enterprise value to free cash flow.

As an example, the table below shows the free cash flow yield for four large cap companies and their P/E ratios in the middle of 2009. Apple (Nasdaq:AAPL) sported a high trailing P/E ratio, thanks to the company's high growth expectations. General Electric (NYSE:GE) had a trailing P/E ratio that reflected a slower growth scenario. Comparing Apple's and GE's free cash flow yield using market capitalization indicated that GE offered more attractive potential at this time. The primary reason for this difference was the large amount of debt that GE carried on its books, primarily from its financial unit. Apple was essentially debt-free. When you substitute market capitalization with the enterprise value as the divisor, Apple becomes a better choice.

Comparing the four companies listed below indicates that Cisco is positioned to perform well with the highest free cash flow yield, based on enterprise value. Lastly, although Fluor had a low P/E ratio, it did look as attractive after taking into consideration its low FCF yield.

The Bottom Line
Free cash flow yield offers investors a better measure of a company's fundamental performance than the widely used P/E ratio. Investors who wish to employ the best fundamental indicator should add free cash flow yield to their repertoire of financial measures. Like any indicator, you should not depend on just one measure. However, it is appropriate to employ measures that give you a fair picture of the fundamental performance of the company you are considering. Free cash flow yield is one such measure.

For additional related reading, check out Analyze Cash Flow The Easy Way and Free Cash Flow: Free, But Not Always Easy.

Related Articles
  1. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  2. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  3. Chart Advisor

    Pay Attention To These Stock Patterns Playing Out

    The stocks are all moving different types of patterns. A breakout could signal a major price move in the trending direction, or it could reverse the trend.
  4. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  5. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  6. Professionals

    4 Must Watch Films and Documentaries for Accountants

    Learn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
  7. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  8. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  9. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  10. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  1. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
  2. Do working capital funds expire?

    While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
  3. Do you discount working capital in net present value (NPV)?

    Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
  4. How is working capital different from fixed capital?

    There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
  5. How much working capital does a small business need?

    The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
  6. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center