What is the 'Free Cash Flow Yield'
The free cash flow yield is an overall return evaluation ratio of a stock, which standardizes the free cash flow per share a company is expected to earn against its market price per share. The ratio is calculated by taking the free cash flow per share divided by the share price. Free cash flow yield is similar in nature to the earnings yield metric, which is usually meant to measure GAAP earnings per share divided by share price.
BREAKING DOWN 'Free Cash Flow Yield'Generally, the lower the ratio, the less attractive the investment is, and vice versa. The logic behind this is that investors would like to pay as little price as possible for as many earnings as possible. Some investors regard free cash flow, which takes into account capital expenditures and other ongoing costs a business incurs to keep itself running, as a more accurate representation of the returns shareholders receive from owning a business. They prefer to free cash flow yield as a valuation metric over an earnings yield.
Cash Flow Versus Earnings
Free cash flow derives from operating cash flow, which is the net result of actual cash received and paid during a company's operations. Using cash flow to measure operating results is different from accounting-based earnings reporting. Earnings track every element of revenue and expense, regardless of cash involvements. While earnings in principle summarize a company's total net income on account, cash flow practically concerns a company's ability to sustain its ongoing operations. The more cash a company amasses from operations, the easier it is to continue carrying out its business and to ultimately generate more earnings. The ability to yield cash flow can be a better indication of a company's longer-term valuation.
Return Versus Value Evaluation
Investors may evaluate a company's worth by comparing its business return with its equity value. Cash flow can be a proper return representation, and market price a close proxy of equity value. Investors may judge a company's worth based on the percentage of its cash flow over the equity's market price, which is referred to as cash flow yield. Alternatively, investors may look at a company's worth using a valuation multiple calculated as its equity's market price over the amount of cash flow. Evaluating an investment using cash flow yield can be more intuitive than a valuation multiple, as cash flow yield directly shows the cash returned as a percentage of the investment.
Free Cash Flow Yield Valuation
In addition to sustaining ongoing operations, cash flow from operations is also a funding source for a company's long-term capital investments. Before tapping into any outside financing, a company first use its operating cash flow to meet capital expenditure requirements. Anything left is referred to as free cash flow and becomes available to equity holders. For investors preferring cash flow yield as a valuation metric over valuation multiples, the free cash flow yield would be a more accurate representation of investment returns, compared to yields based on cash flow not fully returnable or accounting earnings.