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Use Free Cash Flow Yield To Find Truly Cheap Stocks

This article is the third in a series that explains how our stock screening strategy differs from all the basic offerings out there. The previous 2 articles can be found below:
  1. Market Capitalization Is Misleading, Use This Instead.
  2. The P/E Ratio Is Antiquated. Here Is Something Better.

Up to this point, we've shown why enterprise value is a far superior statistic than market capitalization for judging the true price of a company. Then we built upon that - and added a few new twists - to show how earnings yield is a much better valuation indicator then the stodgy old P/E ratio.

In this article, we'll add another valuation tool to the toolbox. One that honors that age-old business wisdom that cash is king.

Free Cash Flow vs. Earnings

We need to start by distinguishing between earnings - the most commonly used indicator of profitability - and free cash flow, which is what a company truly earned over a period of time.

The income statement, which reports a company's earnings, contains a lot of assumptions and accounting methods that don't necessarily reflect the actual money coming in and out of the business. A lot of those expenses on the income statement are not really cash costs. Depreciation and amortization are simply schedules that apply past cash costs over a period of time. Stock based compensation is an accounting estimation of the ultimate future cash cost of stock issued as payment. Impairment charges apply a big chunk of past cash costs at once to earnings.

On the other hand, the cash flow statement, tracking a company's actual cash flow, contains cash charges that are not reflected on the income statement. Companies capitalize equipment expenses all the time, paying their full cost up front and then amortizing that cost over a useful life estimate. Inventory cash costs are paid upfront and then reflected on the income statement when items are sold. And so on.

A newspaper subscription is a good way to illustrate the difference. When you buy an annual subscription, say for $120, you pay that $120 up front (a cash cost), but that subscription is then good for 12 months. On a cash flow statement, the $120 shows up in the first month, and then no more costs for the rest of the year. On an income statement, though, that subscription cost would be reflected as a $12 charge each month.

Free Cash Flow

The cash flow statement's analog to net income is cash from operations. This shows you very discretely how much cash a company produced or consumed over a quarter or year.

We do have to make one adjustment, though. There are some cash charges that a company needs to routinely take to keep its business running. Google has to replace old or busted servers. Ford has to maintain its assembly lines. Macy's has to replace carpets, cases, and light fixtures. These are called capital expenditures, and we need to subtract them from cash from operations to get free cash flow - the true amount of cash available to the business to expand, buy back shares, or pay a dividend. We use a slightly different free cash flow calculation to account for only maintenance expenses, you can read more about that here.

Free Cash Flow Yield and How To Use It

Once we have free cash flow, we can easily use the earnings yield formula to get free cash flow yield, a comparable valuation statistic:

Free Cash Flow Yield = Free Cash Flow / Enterprise Value

Free cash flow yield is an excellent alternative valuation statistic. Cash is really king in business... All kinds of accounting assumptions and tricks can be used to gin up earnings, but cash flow is much harder to game. Companies that are not generating a lot of cash flow are going to have serious difficulties providing adequate shareholder returns, and if they have a lot of debt obligations, the risk becomes even higher.

In my opinion, the best use of free cash flow yield is in conjunction with earnings yield, as a kind of "second opinion" that a stock truly is cheap against its recent earnings AND cash generation power. This is how our Deep Value Spell is generated, ranking the market's stocks by just earnings and free cash flow yield.

Below are 2 examples where considering free cash flow yield helps us out:

Case #1: Cheap By Earnings, Expensive By Cash Flow

Chicago Bridge & Iron

A good example of where earnings can be misleading is in the engineering & construction (E&C) field, where projects are paid for usually before or after completion, but revenues are amortized over the project period. In the case of Chicago Bridge & Iron (CBI), we can see this very vividly:

Last 5 years reported operating earnings: $3.61 billion

Last 5 years operating cash flows: $711 million

That's less than 20% of earnings being converted to cash! CBI's legacy Shaw nuclear contracts are a big reason why, with drawn-out project timelines delaying payments over and over again. Although the company recently divested most of the Shaw assets, we don't know when - or if - it will receive the cash payments for those contracts.

Chicago Bridge is a good example of how free cash yield can help us. While the company can be - and is - part of the Magic Recipe on an earnings basis (16% earnings yield), its lack of cash flow disqualifies it from the Deep Value screen (no cash flow = no free cash flow yield).

Case #2: Expensive by Earnings, Cheap By Cash Flow

Take Two

This situation usually happens in the other direction: when a firm amortizes large costs over a period of years. Take Two Interactive (TTWO) is a good example here. The firm is still amortizing the huge development costs of Grand Theft Auto 5 over its "useful life" of 5+ years, even though principal development ended years ago. As a result, quarterly amortization charges make Take Two look unprofitable, even though it is generating plenty of cash flow. Observe:

Last 5 years reported operating earnings: $155 million

Last 5 years operating cash flows: $958 million

Being "unprofitable", Take Two has no earnings yield, but on a free cash flow yield basis its valuation looks very enticing at over 16%. Because it is cash flow positive, it is a candidate for the Quality Growth Spell and, with its solid 29% 3-year revenue growth rate, is indeed a current member of that screen.

Conclusion

Free cash flow yield is yet another valuation tool in the tool belt. It is especially useful when combined with earnings yield to "double-check" that a company is indeed valued cheaply, and is also useful for finding "unprofitable" companies that are in fact generating plenty of business-sustaining cash flow.

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