Evaluating Stocks using Free Cash Flow
Measures of free cash flow and free cash flow yield are frequently used in stock selection and analysis. Unfortunately, free cash flow is often defined loosely and in different ways by different pundits (analysts) . All free cash flow measures are not equal, or even comparable. In view of the current environment, in which many companies have taken on a tremendous amount of debt to survive the pandemic period, the distinction between basic measures of free cash flow and more sophisticated measures such as free cash flow to the firm and free cash flow to equity have become more important than ever in stock selection.
 This article is based on Equity Asset Valuation, 4th Edition, Wiley/CFA Institute Investment Series, 2020 which I co-authored with colleagues (full disclosure – I receive No royalties on sales of this book).
When you are purchasing stock in a company, you are buying a piece of the business. You are an owner, as opposed to a creditor that is loaning money to the company. Whether you are buying 100 shares or a substantial percentage ownership, you should evaluate the investment as an owner. To be successful a company must be able to generate revenues by selling its goods and/or services at a higher price than the all-in costs of providing those goods and services. In the long run the business must generate both revenues and profits. It must also be able to turn those revenues and profits back into cash which can be distributed to owners, used to pay creditors or reinvested in the business. Not all companies are equally successful at this last step. They may be generating sales by allowing very lax credit terms, in which case the cash collection period could be lengthy or even indefinite. Many companies with rapidly growing revenues have ended up in bankruptcy as a result. In evaluating a company, you need to look at many factors, but among the four most critical are the ability to generate revenues, grow those revenues over time (otherwise you will not keep up with inflation!), generate profits from those revenues and turn those profits into cash flow. You cannot pay your bills with net income alone – that requires cold hard cash.
Professional analysts value companies using a number of different methods, but one of the most common and successful is a discounted cash flow analysis where they forecast revenues, expenses and free cash flow and compute what a fair value is today for the stock. Another way of looking at it is to take the current stock price as given and compute the return you would receive over time based upon the free cash flow you expect the company to provide in the future. This approach involves calculating and evaluating a company’s free cash flow yield. Unfortunately, there are many ways to compute free cash flow (FCF) yield. In a May 2020 blog post, I discussed Basic FCF Yield – the most fundamental of them all. Today, we will look at more nuanced measures of free cash flow and free cash flow yield.
A Positive Free Cash Flow Story
Let’s look at some real company data to gain an understanding of what free cash flow measures look like. Revenue, earnings and cash flow of HP Inc.(HPQ) over the recent years were as follows:
 I currently have a long position in HPQ.
Over the past 4+ years, HP has generated increasing revenues in all but one year and has had a large increase in revenue in the trailing 12 months ended April 29.2021. They have been successful in generating a profit from these revenues. Note that the large increase in net income in FYE 10/31/2018 included over $2 million of income tax benefit which is non-recurring and should be ignored in evaluating future prospects.
HP has been very successful at turning net income into cash flow. Operating cash flow is the actual net cash received from collecting from customers and paying cash-based expenses. Over the long term you should expect cash flow from operations to exceed net income. This is because there are some expenses that are always non-cash. The largest such expense is depreciation on the property, plant and equipment used in the business. That is why we then compute basic free cash flow. Basic free cash flow is the cash flow generated from operating the business minus the additional cash capital expenditures we need to replace or improve our property, plant and equipment. HP’s basic free cash flow exceeds their net income in all but the year of the non-cash tax benefit. This is what we like to see; however, it does not tell us the entire picture. Who does this cash flow belong to? If you say the owners or stockholders you are partially correct.
Companies have two main ways of raising capital to operate the business – debt and equity (stock). Basic free cash flow is needed to repay BOTH over the long term. To be more precise, we use basic free cash flow with one adjustment to determine Free Cash Flow to the Firm – the free cash flow generated by the business that is available to pay both creditors and investors. The adjustment that is required is related to interest expense. Under U.S. accounting principles followed by HP, interest expense paid to creditors is considered to be an operating cash outflow so we add that back adjusted for the impact of taxes. This represents the free cash flow available to both debt and equity capital providers before any payments to those providers.
FCFF can be reinvested in the business, used to repay creditors or used to repay stockholders. The latter could be in the form of dividends or stock buybacks. In order to determine if this is a good FCFF compared to other investment alternatives we need to compute FCFF Yield. This is the free cash flow to the firm divided by the enterprise value. Enterprise value is the value of the stock holdings (market capitalization) plus the value of debt. Think of this as the amount of capital the debt holders and stockholders have invested in the company. It is important that we match the numerator and denominator so that if free cash flow to all capital providers is in the numerator the value of the that total capital must be used in the denominator.
For HP the trailing 12 months FCFF Yield, based on enterprise value, is 13.9%. This means that for every $100 of capital tied up in the company that HP generated $13.9 of Free Cash Flow. Further, on average HP tends to generate a free cash flow yield of about 10%. Since this is the cash flow available to all capital providers we have to take another step to determine the free cash flow available to equity (stock holders).
Free cash flow available to equity holders (FCFE) is basic free cash flow adjusted for any net borrowing/debt repayment. Note that in HP’s case they are sometimes a net borrower and sometimes a net debt payer, so FCFE varies quite a bit. On average HP’s FCFE Yield exceeds FCFF Yield. Why? HP’s cost of debt right now is about 3.3%. They are earning FCFF Yield of 10%+ each year but only paying 3.3% on debt. The net benefit (spread) accrues to the stockholders.
What is a normal FCFF and FCFE Yield? Good question. I wish I had a good answer. Databases vary on which FCF yield they use and averages are not regularly reported on stock indices like the SP500. When data is reported it tends to be a Basic Free Cash Flow Yield determined by dividing by market capitalization. This is imperfect as the numerator approximates free cash flow to the firm (all capital providers) while the denominator only includes stockholders’ investment. This overstates the true FCFF Yield. On this basis, the mean Basic FCF Yield for the SP500 is 6.5% and the median is 4.7%. FCFF Yield would be lower than this since it would include debt in the denominator. Recent data for the trailing 12 months ended with the first quarter of 2021 shows a FCFF Yield for the SP500 of 1.6%. The cheapest sector, basic materials, has a FCFF Yield of about 5.1%. Some public sources compute Basic Free Cash Flow yield by only market cap. A poor choice, but it is out there and used. Make sure you understand what method any data source is using if you are not computing FCF Yields yourself. To compare to public available aggregate data HP’s Basic Free Cash Flow Yield can be computed as below.
HP’s basic free cash flow yield is about 11% on average placing it in the top 20% of large cap companies based (among the 20% least expensive companies relative to the cash flow they generate).
If averages are hard to come by, what should you look for? Using a historical FCFF Yield which is more stable then FCFE Yield and represents the overall cash return the company is generating is a good start in identifying potential investments. What we really want to know, however, is what future FCFF will be including and how much it will grow over time. A company might be selling at an attractive FCFF Yield now but cash flows might be expected to decline in the future, making it a poor investment.
Enterprise Value = Next year’s FCFF/ (Required Rate of Return minus expected growth in FCFF)
With some algebraic manipulation we find that:
Expected Return = (Next year’s FCFF/Enterprise Value) + Expected Growth
Expected Return = Forward FCFF Yield + Expected Growth in FCFF
Personally, I look to find companies have a FCFF Yield of at least 5% plus the possibility of growing that FCFF by more than 5% per year. The overall expectation would be to achieve an expected return of more than 10%. . How much more depends on the risk and size of the company. This is an expected return to both debt and equity holders. With a low cost of debt currently, the expected return to the equity investor would be even higher. My overall market expectation is much more modest. Give current valuations I would expect overall stock returns to be more like 6-7% a year in the coming decade. However, to take the time to analyze and manage investments in individual securities I expect to be paid more.
A Negative Free Cash Flow Story
Now let’s look at an industry that has been incredibly impacted by the global pandemic to see the impact on cash flows, capitalization and ultimately the company’s ability to generate cash flows for owners. Carnival Cruise Lines (CCL) had the following data over the past few years:
 I have no positions in CCL, long or short.
The impact of the pandemic is clear with revenues dropping to near zero, substantial continuing carrying costs and significant increases in debt to stay afloat! Note the impact of this leverage is for FCFE yield to be much lower than FCFF yield in the last few years. Note also the shift in capitalization. While the company’s enterprise value is very close to where it was 4 years ago the amount of debt has tripled. Enterprise value was primarily from the value of the stock 4 years ago but is over 50% debt today!
This presents substantial risks to the ability to generate a cash flow return to equity holders. Note that several years ago they were generating a free cash flow to the firm yield of about 4.5%. In 2017 they leveraged this to a free cash flow to equity yield of 7.2%. Even if they return to FCFF Yields of 4.5% if operations return to “normal” they will need that FCFF to service the substantial debt. Specifically, if they are able to generate FCFF of $2.5 billion in the future as they did in 2017, they would need $1.5 billion of that to service just the interest. Not leaving much for stockholders.
As you can from the above examples, all free cash flow is not created equal. Free cash flow, however, is a very useful metric in evaluating a company and its ability to return cash to investors in the future. It is beneficial to take care in using basic free cash flow measures and ensuring that the metrics you are using properly measure cash flow to whom – investors, creditors or both. Further, from a valuation perspective we need to consider a company’s ability not only to generate consistent cash flows but to grow them over time. Your overall expected return is based on expected cash flow yields and the growth of cash flow over time.