Free Cash Flow (FCF) and Free Cash Flow Yield (FCFY) are important metrics for all stakeholders (common stock owners, debt holders, preferred stock holders, convertible stock holders, etc.) because it provides a more accurate picture of an entity’s financial health than net income. Net income includes non-cash accounting adjustments and may not accurately reflect crucial aspects of a company’s health.
Free Cash Flow metrics evaluate whether a company has sufficient cash resources to meet the goals of the entity and its’ stakeholders (debt reduction, dividends, stock buybacks, acquisitions, etc.).
Free Cash Flow Calculation
Free Cash Flow (FCF) = Operating Cash Flow (OCF) – Capital Expenditures
I like operating cash flow because it reports the amount of cash from operations generated by a company. This metric can easily be found in the company cash flow statement. Free cash flow is operating cash flow minus capital expenditures.
Free Cash Flow is the cash available to distribute to stakeholders (debt and equity holders) after the bills are paid, and after provisions have been made for the future of the enterprise (capital expenditures). Free Cash Flow is important because it represents the money available to enhance shareholders.
This important metric can be used as a ratio to provide one of the most powerfully useful ratios in stock analysis:
Free Cash Flow Yield (FCFY)
We can take this valuable information and produce a ratio that is one of the most useful metrics in stock analysis: Free Cash Flow Yield.
Free Cash Flow Yield = Free Cash Flow / Market Capitalization
This ratio expresses the percentage of money left over for shareholders compared to the price of the stock. The ratio is exceedingly valuable to an investor because it relates to the value you are receiving for your investment dollar.
A company could have high cash flow compared to its assets but the stock price be so expensive that the value for the investor is low. It’s also possible that cash flow compared to company assets could be low but the stock price be such a bargain that the value for the investor is high.