Understanding Liability-Adjusted Cash Flow Yield

Investors, particularly those who call themselves value investors, place a great deal of emphasis on a company's ability to produce free cash flow and the valuation of the company's shares. Unfortunately, there are relatively few handy ratios for quickly evaluating a company by these metrics, and those that are pressed into service (like enterprise value to EBITDA) have some notable deficits.
TUTORIAL: Financial Ratios

Given the importance of both free cash flow and valuation, investors may want to consider adding liability-adjusted cash flow yield (LACFY) to their repertoire of analysis tools. LACFY offers investors an ability to quickly gauge the value of a company's stock relative to its free cash flow history and make relative valuation calls within an industry or sector, as well as a quick acid test of a company's dividend policy. Though LACFY is not perfect and does not work in all situations, it holds up well as a fast and easy evaluation metric. (For more, check out Free Cash Flow Yield: The Best Fundamental Indicator.)

Defining LACFY
The calculation of LACFY is straightforward. Take the historical average of a company's free cash flow (that is operating cash flow minus capital expenditures) and divide that number by the sum of market capitalization, liabilities and current assets net of inventory. LACFY is basically a measure of the "cash on cash" returns that an investor could expect if he or she owned the entire company outright.

In other words:

LACFY = 10-year average free cash flow ÷ (market capitalization + total liabilities – (current assets – inventory))

This equation is simple, but it elegantly handles a few of the thornier aspects of cash flow-based methodologies. By using a multi-year average, LACFY largely neutralizes the year-to-year volatility that can come from working capital adjustments (running down inventory, for instance) or changes in cap-ex and can capture what should be a full economic cycle for a company.

How to Use LACFY
LACFY can offer investors a handy way to assess the company's valuation relative to other instruments like a Treasury bond. The yield that the equation produces is readily comparable to a Treasury yield – if the stock is "yielding" more, it has passed one valuation hurdle and is worth further research. It is also possible to compare companies within the same industry using this metric. Care should be taken, though, to make fair comparisons – an emerging company with a few years of negative free cash flow mixed in will likely not stand up well against an established company that is harvesting cash from decades of brand equity and operating assets.

LACFY can also be a useful tool in assessing the quality and stability of a company's dividend. While a company has some short-term alternatives for funding a dividend that are independent of operations (issuing debt or equity, as well as selling assets), eventually dividends depend upon the free cash flow that a company can produce. If the company's dividend yield is above the LACFY, investors should dig deeper and assess whether that dividend is truly sustainable over the long term. (To learn more, see Your Dividend Payout: Can You Count On It?)

Advantages of LACFY
Liability-adjusted cash flow yield removes the subjectivity of discount rates and growth projections from the valuation exercise. Though it is true that Wall Street is always looking forward at what a company will do, and LACFY looks back at what a company has done, it is also true that analysts and investors are often substantially over-optimistic when it comes to future growth.

This method also produces a rather intuitive result - a "yield" number than can readily be compared to the yield on long-term Treasury securities. Perhaps it seems illogical to essentially use the same discount rate (the comparable Treasury bond) for all stocks, but consider this – the LACFY equation essentially imposes a discount on risky ideas like emerging growth stocks and volatile cyclical companies by virtue of that 10-year average. A steady cash flow producer like Coca-Cola will likely fare better than a new software company or cyclical copper miner.

LACFY also forces investors to account for how a company is capitalized. In other words, a company that requires $100 of capital to produce $1 of free cash should not carry the same valuation as a company that needs only $10 to produce that same dollar of free cash flow. (Learn more in Analyze Cash Flow The Easy Way.)

Drawbacks
LACFY shares a drawback common to all backward-looking analysis; it gives no credit to improvements that the company may make in the future and does not account for the fact that the future may be better (or worse). Emerging growth companies, then, will almost never fare well by this metric.

This approach is likewise problematic for turnarounds and companies with significant negative free cash flow in recent years. If a company has had negative or depressed free cash flow, LACFY is going to impose a much higher hurdle and investors may end up dismissing companies as "overvalued."

To some extent, investors can work around this. If a 10-year track record of free cash flow is not available, a five-year analysis may yet provide some useful information. Investors may also wish to adjust the 10-year average for years that were truly aberrant relative to the trend, but should be aware that tinkering too much can reduce the built-in discounting mechanism of that 10-year average. Likewise, an investor can reverse the equation to figure out the sort of cash flow an emerging company needs to be a good buy and whether that figure is realistic in a short time frame.

It is also important to reiterate that LACFY is just one metric for an investor to consider; LACFY can be very useful as a filter, but it should not be the basis of buy/sell investment decisions. A company about to go into prolonged decline will look great by this metric (especially if the market is already aware and sold off the stock), while a young growth champion may look terrible. In other words, responsible investors must go deeper than whatever result the LACFY produces. (To learn more, read The Top 3 Pitfalls Of Discounted Cash Flow Analysis.)

The Bottom Line
While not a one-stop decision-maker, LACFY is nevertheless a useful tool in quickly assessing companies that may merit further scrutiny. Properly used, it is a tool that can point to undervalued cash flow generation, as well as potentially unstable or unsustainable dividend-payers. Moreover, there are few other options that examine both cash flow and capitalization, so value investors may want to try LACFY as a screening and valuation tool in their stock research.

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