Free cash flow (FCF) is the cash a company has after it’s paid its capital expenditures. It’s used to buy back stocks, pay dividends, or participate in mergers and acquisitions. But, a company with high FCF yields in the past may not necessarily have strong FCF yields going forward.
That’s why Michael Mack, Associate Portfolio Manager from VictoryShares and Solutions, argued that “you need to take a forward-looking approach” when seeking companies with high FCF yields. This involves taking a company’s trailing FCF and combining it with its forward FCF.
On a webcast hosted by VettaFi, Mack said the combination of a company’s trailing and forward FCF is the best indication of where its FCF is likely to be in the future. “It’s important to understand that at the end of the day, the value of a business is based on its potential future cash flows,” Mack added.
Target Profitable Companies With High FCF Yields
The VictoryShares Free Cash Flow ETF (VFLO) invests in profitable U.S. large-cap companies with high FCF yields. The ETF seeks to track the performance of the Victory U.S. Large Cap Free Cash Flow Index1, which calculates FCF yield by dividing expected FCF by enterprise value.
Expected FCF is the average of the trailing 12-month FCF and the next 12-month forward FCF. Enterprise value measures a company’s total value, often used as a more comprehensive alternative to equity market capitalization.
“Enterprise value looks at the company’s entire capital structure,” Mack said. “And so, its not just its market value…it also looks at the debt and cash it has on its balance sheet.”
Tilting Towards Companies With Stronger Balance Sheets
Mack explained that a highly leveraged company “might appear cheap on a trailing free cash flow yield basis.” But that’s because “they have a lot of debt on their balance sheet. And once you factor in that debt, you see they’re no longer cheap.”
“By using enterprise value, at the end of the day, it’s going to tilt you towards companies with stronger balance sheets,” Mack said. “Which is one of the ways we see free cash flow being a more resilient factor over time.”
The Index methodology selects companies from a universe² of U.S. large-cap stocks by applying a profitability screen. It then selects companies with the highest free cash flow yields that exhibit relatively higher growth potential based on trailing and forward-looking metrics.
For more news, information, and analysis, visit the Free Cash Flow Channel.
VettaFi LLC (“VettaFi”) is the index provider for VFLO, for which it receives an index licensing fee. However, VFLO is not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of VFLO.
Enterprise value (EV) measures a company’s total value, often used as a more comprehensive alternative to equity market capitalization.
1/ This Index calculates free cash flow yield by dividing expected free cash flow by enterprise value. You cannot invest directly in an index.
2/ The Victory U.S. Large Cap Free Cash Flow Index’s starting universe is the VettaFi 1000 Index, which consists of market cap-weighted U.S. large-cap stocks.
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