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Free Cash Yield: The Best Valuation Statistic?

Valuation of stocks is a topic on which mountains of material has been written, and it has been discussed on the internet ad-nauseam. It's easy to see why - valuation is probably the single most important part of consistently picking winning investments. Get it right (or close to right), and you give yourself a great chance of significant gain with minimal risk. Get it wrong and... well, you know the rest!

In fundamental stock analysis, there are a number of valuation statistics, many of which have been discussed on this blog before. The most popular, of course, is the price-to-earnings ratio, or P/E. This ratio is easily calculated and can be found almost anywhere you can find a stock price. But is it really the single best valuation statistic to use to determine quickly whether a company may be undervalued?

First, the benefits. As mentioned, P/E is easily accessible. Second, it is a good point of comparison. If a stock's P/E ratio is lower than the overall market's, lower than it's primary competitors, and lower than the specific stock's historical average, the stock is likely to be undervalued and warrants additional inspection.

But there are drawbacks to the P/E ratio as well. First, P/E can be widely skewed by one time charges or benefits. For example, if a company sells off a portion of it's business, the gain on the sale is recorded as earnings, raising the "E" portion of the ratio and bringing the overall P/E down. If we don't dig deeper to ensure that the P/E ratio we're comparing against competitors, the market, and historical average represents an accurate number for the core business, we can be fooled into thinking it's undervalued.

Second, P/E includes charges and benefits not related to the core business. Non-operating income and charges such as interest paid on cash and investments, other investment gains and losses, income taxes, and other items are included in the P/E. Since these can vary considerably between companies, but have no bearing on how good or bad the business itself is, they can skew the ratio, making comparisons with competitors less than perfect.

Joel Greenblatt provides us with a similar, but better, statistic in The Little Book that Beats the Market: Earnings Yield. In essence, earnings yield simply flips the P/E ratio upside down, making the ratio into a percentage. For example, a 15 P/E becomes a 6.7% earnings yield. Turning P/E into a yield percentage is useful, because we can then compare it against bond or treasury yields. The current yield on a 10 year treasury is about 3.5%, so the stock would appear to give us 3.2% extra return for the risk involved.

But Mr. Greenblatt goes farther with his version of the earnings yield. For "E" portion in his version refers to operating earnings. Operating earnings are also known as EBIT - earnings before interest and taxes, which strips out the non-operating costs and revenue from the result, allowing for a more meaningful comparison between companies. The "P" portion refers to Enterprise Value. Enterprise value is simply market capitalization (the price the market has put on the company, or share price times number of shares), plus debt, minus cash on hand. By making these changes, Greenblatt incorporates balance sheet risk (or lack of) into his earnings yield calculation, while making it a better comparison between companies and against treasury and bond yields. Clearly, his version of earnings yield is a better metric than straight P/E.

One problem remains... earnings as reported is not always a tangible figure. A lot of assumptions are used by accountants to come up with earnings figures. First, they must decide what is actually a sale - some customers may never pay, and contracts can always be renegotiated or canceled, even after being reported as revenue in the income statement. Also, income statements include assumptions for such things as depreciation of property and equipment, the eventual value of stock options granted, and so forth.

This is why the cash flow statement exists. A company can use accounting tricks to fake earnings, but cold hard cash is harder to fake - the company either collected it or it didn't. What's more, the true value of a business is simply the discounted sum of all future cash flows, according to accepted finance theory. So, cash earned is clearly a better measure of business performance than earnings. Free cash flow is a step better, as it subtracts out the costs the company must pay to keep the business operating (such as equipment repairs, computer replacements, etc). MagicDiligence uses the depreciation figure to approximate these costs.

Once we have the free cash flow figure, we simply plug that in as the "E" portion of Greenblatt's earnings yield equation, and we have free cash flow yield. This is a powerful figure - it measures a company's cash generation, balance sheet risk, and share price all at once, and allows a meaningful comparison against both other stocks and fixed income assets like bonds and t-bills. No other valuation statistic gives you this much relevant information.

For those who are lost, I'll run through a simple example using my favorite lab rat - Johnson & Johnson (JNJ). To calculate earnings yield, here are the values you need from the 10-K. They've been gathered for this example:

  • Net Cash from Operations (Cash Flow Statement)
  • Depreciation and Amortization (Cash Flow Statement)
  • Cash and Short-term Investments (Balance Sheet)
  • Long-term Debt (Balance Sheet)
  • Diluted Shares Outstanding (usually in the Income Statement, although sometimes you need to look in the footnotes).
  • Current share price (Yahoo! or wherever)

The values from the last 10-K are (in millions):

  • 15,249
  • 2,777
  • 9,315 (7,770 cash + 1,545 short-term investments)
  • 7,074
  • 2,910.70
  • 64.88

First, we calculate free cash flow by subtracting depreciation from net cash earned:

  • Free cash flow = (15,249 - 2,777) = 12,472

Next, we calculate enterprise value. First calculate market capitalization by multiplying share price by number of shares. Then add debt and subtract cash and short-term investments to that figure:

  • Market Cap = (64.88 * 2910.70) = 189,000
  • Enterprise Value = (189,000 + 7,074 - 9,315) = 186,759

Free cash yield is then FCF/EV, or:

  • Free cash yield = 12,472 / 186,759 = 6.68%

This seems like a fair premium to the low treasury bill rate, for such a quality company. Stocks get into real bargain territory when free cash yield approaches 10% but remember, fundamental analysis is needed before putting your hard earned money into the stock. That's what MagicDiligence is here for!

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Posted by scopee on 2008-11-12 07:49:24

great site steve..thank the above, is it right to subtract depreciation from net cash from operations? i thought that depreciation was added back to income specifically to account for the fact that it was docked but does not represent a 'real' cash outflow...i am just wondering why you would now subtract it back out

also, i would expect capital spending to be subtracted from the net cash from operations figure to arrive at free cash flow

any thoughts?

rio t.

Posted by Steve on 2008-11-24 09:36:41

Hi Rio,

The classic definition of free cash flow is indeed (cash from operations - capital expenditures). However, Greenblatt in his book and MagicDiligence as well uses the Depreciation number instead. There are a couple reasons for this. One is that capital expenditures includes growth expenditures, which is just another way to try and increase shareholder value, not conceptually different from paying a dividend or buying back shares. We want only maintenance capital expenditures, and the depreciation cost gets us close.

A second reason is that depreciation costs are less "jumpy" than capex, allowing you to identify cash flow trends more easily.

You will notice that with consistent companies, depreciation and capex are pretty similar.

Posted by scopee on 2009-01-23 08:07:18

hi steve,

again, great site and thanks so much for your informative response...i see the logic of using depreciation as a proxy for capex now.

one other thing i was wondering about was that in your definition of free cash flow, the "net cash from operations" from the cash flow statement flows from the income statement, at which point it has been docked for interest and taxes...thus, in theory isn't this going against the argument greenblatt provides for using EBIT, which in his view, "puts companies with different debt levels and different tax rates on an equal footing"? would it not be more appropriate to use (EBIT minus depreciation) along the same lines?

your thoughts?


rio t.

Posted by dragontoad on 2009-06-07 19:01:02

Hi- I have been wondering the same thing as Rio... Is there a simple way to adjust your Sensible Free Cash Flow (SFCF) to be pre-tax, pre-interest expense?

As I understand it, the payment of Income Tax reported in the income statement is not factored into "net cash from operations" until it has actually been paid.. The payment due date for corporate taxes is 9 months and 1 day after the last day of the accounting period, so the income taxes being factored into SFCF are those paid ~9 months ago, and not the taxes for the current period..

So, if we were going to calculate pre-tax, pre-interest SFCF, would it just be:

SFCF + Interest Expense Paid + Income tax 3 quarters ago??


Posted by Steve on 2009-06-11 04:49:07

I see what you guys are getting at - ranking stocks by free cash flow before interest and income taxes instead of using operating earnings. It is an interesting concept, one that could further filter out accounting shenanigans from the MFI screen, as unscrupulous managers can easily manipulate operating earnings by moving a few expenses around in the income statement.

There are a few practical problems. Oddly, it is sometimes difficult to locate income tax payments in cash flow statements. Going back to income taxes 3 quarters ago is probably more work than value provided. However, I think it is an interesting concept that could further improve the MFI screen if implemented smartly.

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