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. Stock Analysis

    Top 5 Stocks Listed on the Australian Securities Exchange for 2016 (RIO)

    Uncover five of the stocks listed on the Australian Stock Exchange (ASX) that offer investors the highest potential for above-average profits in 2016.
  2. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  3. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  4. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  5. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  6. Investing

    Don't Freak Out Over Black Swans; Be Prepared

    Could 2016 be a big year for black swans? Who knows? Here's what black swans are, how they can devastate the unprepared, and how the prepared can emerge unscathed.
  7. Economics

    The Truth about Productivity

    Why has labor market productivity slowed sharply around the world in recent years? One of the greatest economic mysteries out there.
  8. Chart Advisor

    Uptrending Stocks Dwindle, a Few Remain (EW, WEC, WR)

    The number of uptrending stocks is shrinking, but here a few that remain in uptrends.
  9. Chart Advisor

    Trade Setups Based on Descending Trend Channels (LBTYK, RRC)

    These descending trend channels have provided reliable sell signals in the past, and are giving the signal again.
  10. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  4. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  5. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  6. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center