Cash flow is vital because if a business runs out of cash it will go bust, even if it appears to be making a decent profit on paper. Hence the oft-quoted business cliché, “cash is king”. Reporting of cash flows is also harder to manipulate in a flattering manner than reporting on earnings (which can be heavily influenced by choice of accounting conventions). This is one reason why investors should look at company valuation using measures based on cash flow as well as those based on profits or book value.
With that in mind, the free cash flow yield (FCFY) is a ratio used to work out the cash flow return on a share as a percentage. Mechanically, if free cash flow is, say, £100m, and the firm’s market capitalisation (the number of shares in issue multiplied by the current price) is £500m, then the FCFY is 20% ((100/500)* 100%).
But what is free cash flow? This is not a number you can find directly from a set of accounts; it requires a bit of hunting around. Put simply, it’s the annual operating cash flow made by the firm after deducting all non-discretionary cash flows. These include tax bills that have to be paid, any interest paid on loans, and any capital expenditure needed to maintain the firm’s operating assets in good working order or to replace such assets as they wear out.
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Once you strip these costs out, you have in effect the cash flow left available to pay dividends to shareholders. As a result, if you’re looking for a stable, sustainable dividend flow in the future, then you want to look for a firm that offers a consistent, high free cash flow. By contrast, if a company’s free cash flow is trending lower over time, this may be a warning sign of trouble ahead. As for the FCFY, the higher the better from a value investor’s perspective – the bigger the yield, the cheaper the stock, all else being equal – although as with any valuation ratio, you should not rely on it in isolation.
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