For long term investors, free cash flow (FCF) is a great stock valuation tool. Even better is the utility of FCF Yield.
Value investors use free cash flow to calculate FCF Yield.
Experts say that use of free cash flow yield is a better valuation tool than P/E and P/B ratio.
Why FCF yield is such a valuable valuation tool?
We know that cash flow management is the most critical factor in managing the day-to-day operation of business.
But now focusing only on cash flow is outdated.
The new trend is to focused on free cash flow instead of only on cash flow.
If a company is able to manage the generation of free cash, it will eventually take care of cash flow as well.
Similarly, investors has also been using few outdated tools.
The tools like P/E, P/B, Earning Yield and PEG are great tools. But with changing times, inclusion of a more relevant accurate tool was necessary.
FCF Yield has managed to bridge the gap between the old tools and requirement of something new and more relevant.
More and more users are now relying on the concept of Free Cash Flow (instead of PAT).
Earlier trends were relying more on PAT (Profit After Tax).
But now the investors have realised that Free Cash Flow is a more accurate indicator of company’s net profit.
FCF Yield & True Value
Use of Free Cash Flow (FCF) as a value indicator is very effective. This is because with the use of FCF helps investors to accurately estimate a stocks true value (intrinsic value).
[You can check my stock analysis worksheet which can also estimate intrinsic value]
If some one does not want to get into the hassle of estimating intrinsic value of stocks, use of FCF yield can be a good compromise.
What makes Free cash flow so useful and relevant?
On one hand where companies may manipulate their PAT figures, it is difficult to manipulate FCF. How?
Free cash is nothing but the amount of cash balance after adjusting for all expenses.
It can be easily depicted from the below formula:
Net cash from operating activity is noting but a combination of below:
- Cash comes in the bank account of company when payments are made by customer.
- Cash moves out of the bank account when payments to vendors, utility bills etc.
In lay mans terms, the net cash that remains in the bank after all collections and payments of expenses is called as “net cash from operating activity”.
What a company is doing to maintain a positive free cash flow?
- It is collecting enough cash from its customers.
- Company is paying all its employees.
- It is paying its suppliers.
- The company is also ensuring that sufficient money is also reinvested (as capital expenditure) back in business to ensure future growth.
If a company, after doing all this, is also able to keep some spare cash (free cash flow) can be tagged as a healthy company.
Where to get data for free cash flow?
Free cash flow is not available off-hand on companies financial reports.
Investors must do their own calculation to obtain free cash flow (FCF) of a company.
Free cash flow is equal to net cash generated from operating activities and subtracting it with capital expenditure.
Generally speaking, both ‘net cash generated by company from operating activity’ and ‘capital expenditure’ can be obtained from ‘cash flow statement’ of company.
A typical cash flow statement looks like this:
Followings are worth noting in above cash flow report:
The company has declaring its Net Profit After Tax (PAT) as Rs 8,700 Crore.
But out of these Rs.8,700 Cr, companies operations has been able to generate net cash of only Rs.5,700 crore (65.5%).
The free cash flow percentage will be even lower.
When Capital Expenditure portion is deducted from “net cash flow from operations”, it comes out to be Rs.4,850 crore.
So, though the company is declaring its net profit as Rs.8.700 crore, but the useful money that the company has in its hands is only Rs.4,850 crore.
- Net Profit = Rs.8,700 Cr.
- Free Cash Flow = Rs.4,850 (55.7% of PAT).
This is the reason why value investors rely more on free cash generated by company rather on the companies PAT.
FCF Yield formula…
To understand the concept of FCF yield, lets see its similarity with earning yield.
What is earning yield?
Inverse of P/E ratio is earning yield.
Earning Yield = 1 / (PE) = EPS / Market Price = Net Profit / Market Capitalisation.
Similarly, FCF Yield = Free Cash Flow / Market Price
Why this comparison of FCF Yield and Earning Yield?
Generally we consider a company better valued if it is showing a high earning yield.
This is not wrong, but stopping our calculation at the level of earning yield itself can lead to mistakes.
Consider a case, where a company is showing high earning yield but a negative FCF yield. Would you like to invest in such a company? No.
When a company can display negative FCF yield and positive earning yield?
- Company is able to bill to its customers, but is not able to collect the due payment.
- The company is under huge expansion mode (high Capital expenditure).
While negative FCF yield due to high Capex can be considered, but negative FCF due to bad collection is not good.
Hence, digging deeper into companies cash flow statements and find its Free Cash Flow Yield is necessary.
One can use the above shown formula to calculate FCF yield.
Another utility of Free Cash Flow…
Earning yield is a good value indicator of a company.
But free cash flow yield gives a more realistic picture of the true valuation of company.
Suppose you have bought shares of company that is currently trading at dividend yield of 4% per annum.
As a value investors it becomes very important for you to check if the company is able to pay the same level of dividends in future.
You can do this by looking at its free cash flow.
Suppose the companies’ dividend payout is 50% of its PAT (Rs 8,700 Crore). Means the company is paying Rs 4,350 Crore in dividends.
The free cash flow of this company is Rs 4,850 Crore.
It means the company is paying Rs 4350 core out of its free cash of Rs 4850 crore (90% of free cash flow).
In this situation, it is most likely that company will cut down its dividend payments in tough times.
Value investors always value share in terms of its dividend payout. But it is equally important for investors to look at dividend payout consistency.
Comparing dividend payout with free cash of company will give you a real picture of whether the present dividend payments can be sustained in years to come.
Free Cash Flow FCF Yield of Top Indian Stocks 2018
- Reliance Industries Ltd.–4.06%
- TCS -4.65%
- HDFC Bank -2.29%
- ITC Ltd.-2.73%
- HDFC -3.97%
- Hindustan Unilever Ltd.-1.44%
- Maruti Suzuki India Ltd.-3.20%
- Infosys Ltd.-4.51%
- ONGC -9.05%
- State Bank of India-3.59%
Check this link to find free cash flow yield of Top 50 Indian stocks in a tabulated form…