Free cash flow yield can be an underutilized metric for value investors. Ratios like the PE ratio and price/book can be more popular among investors, but both have significant drawbacks, especially in a world driven by companies with high intangible assets. Free cash flow yield can help address these problems and was able to more accurately value many of the big tech companies when the other metrics painted a less accurate picture.
What is Free Cash Flow?
Before diving into free cash flow yield, it’s important to understand free cash flow itself. Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It’s calculated by subtracting capital expenditures from operating cash flow.
Free cash flow is crucial because it shows how much money a company has left over to reinvest in the business, make acquisitions, pay dividends, buy back stock, or pay down debt. Unlike earnings, which can be manipulated through accounting practices, free cash flow is harder to artificially inflate.
Defining Free Cash Flow Yield
Free cash flow yield is a valuation metric that compares a company’s free cash flow per share to its market price per share. It’s calculated by dividing free cash flow per share by the current share price:
FCF Yield = Free Cash Flow per Share / Current Share Price
This ratio essentially shows how much cash a company generates relative to its stock price. A higher FCF yield generally indicates that a company is generating more cash relative to its valuation, potentially making it a more attractive investment.
Why Free Cash Flow Yield Matters
Free cash flow yield is an important metric for several reasons:
- Valuation Tool: It helps investors assess whether a stock is potentially undervalued. A high FCF yield may indicate that a stock is undervalued relative to the cash it’s generating.
- Quality Indicator: Companies with consistently high FCF yields often have strong business models and efficient operations.
- Dividend and Buyback Potential: High FCF yield can signal a company’s ability to return cash to shareholders through dividends or share buybacks.
- Acquisition Capacity: Companies with high FCF yields may have more flexibility to make strategic acquisitions.
- Debt Repayment: Strong free cash flow can be used to pay down debt, improving a company’s financial health.
Academic Research on Free Cash Flow Yield
The paper “A Free Cash Flow Investment Anomaly” by Hackel and Livnat examines the relationship between free cash flow (FCF) and stock returns, presenting evidence of an investment anomaly. The authors explore the idea that companies with high free cash flow, when compared to their capital expenditures, tend to outperform in the stock market. They argue that free cash flow is a key indicator of a firm’s financial health and potential for value creation, as it represents the cash available after necessary investments have been made. The study finds that firms with higher free cash flow to capital expenditure ratios often experience higher future stock returns, suggesting that investors may undervalue the importance of free cash flow in their evaluations.
The paper also highlights that the market’s mispricing of free cash flow creates opportunities for investors to generate abnormal returns by focusing on companies with strong free cash flow metrics. The authors emphasize that traditional valuation models, which often focus on earnings or book values, may overlook the significance of free cash flow as a predictor of future performance. Their findings suggest that incorporating free cash flow analysis into investment strategies could improve stock selection and enhance portfolio returns.
5 Stocks with High Free Cash Flow Yields
Now let’s examine five stocks that currently have high free cash flow yields and score well according to Validea’s guru-inspired models:
HF Sinclair is an independent energy company that produces and markets light products such as gasoline, diesel fuel, jet fuel, and renewable diesel.
DINO has a free cash flow yield of 17.07%, which is quite high. The stock scores particularly well (100%) on Validea’s Value Composite Investor model, inspired by James O’Shaughnessy. This model favors stocks with strong value characteristics across multiple metrics. DINO also scores 94% on the Acquirer’s Multiple model, which looks for cheap stocks based on their enterprise value relative to operating earnings.
Bank of America is one of the largest financial institutions in the United States, offering a wide range of banking and financial services.
BAC has a free cash flow yield of 8.40%. The stock scores 100% on both the Growth/Value Investor model (based on James P. O’Shaughnessy) and the Multi-Factor Investor model (based on Pim van Vliet). These models favor stocks with a combination of value, growth, and low volatility characteristics.
Valero Energy is a multinational manufacturer and marketer of transportation fuels and petrochemical products.
VLO boasts a free cash flow yield of 13.03%. It scores 94% on the Acquirer’s Multiple model and 93% on both the P/E Growth Investor model (based on Peter Lynch) and the Multi-Factor Investor model. These high scores reflect VLO’s combination of value characteristics and strong earnings growth.
Arrow Electronics is a global provider of products, services, and solutions to industrial and commercial users of electronic components and enterprise computing solutions.
ARW has a free cash flow yield of 8.40%. The stock scores 92% on the Value Composite Investor model and 91% on the P/E Growth Investor model. These high scores indicate that ARW exhibits strong value characteristics while also demonstrating solid earnings growth.
American Express is a globally integrated payments company known for its credit card, charge card, and traveler’s cheque businesses.
AXP has a free cash flow yield of 8.28%. It scores 100% on the Multi-Factor Investor model and 94% on the Twin Momentum Investor model (based on Dashan Huang). These high scores reflect AXP’s combination of low volatility, strong momentum, and solid fundamental characteristics.
Free cash flow yield is a powerful metric that can help investors identify potentially undervalued stocks with strong cash-generating abilities. The five stocks discussed above not only demonstrate high free cash flow yields but also score well across various investment strategies modeled by Validea.
Further Research
