Sunday, January 13, 2008

Free Cash Flow Yield or FCF

One advanced but quite useful financial ratio that has not been discussed on this blog is the Free Cash Flow Yield. This no. tries to determine how much return can an investor expect after the company has made its money and invested what it needs for future operations. It also gives an indication of how much the dividend yield could be.

This ratio is not called an advanced ratio for nothing. For those who think investment is easy, well sorry, you have to read maybe 5-6 posts on this blog in order just to understand this one. I have added the links on all the keywords. Anyways, here's the basic.

A company generates cashflow based on its day-to-day operations. Eg. a hawker selling bar chor mee gets money fr his customers. This no. is called Cashflow from Operations.

Next, he needs to spend some of this cashflow on equipment to maintain its operations (bowls, knives, noodle cutting machine etc.) This no. is called Capex which is the short-form for capital expenditure.

When you deduct Capex from Cashflow from Operations, you get a no. called the Free Cash Flow. Basically, that's what's left that can be distributed to shareholders or to pay down debt. If the company has no debt, it's basically money that can be paid to the shareholders.

Next we try to compared Free Cash Flow or FCF with the stock price. So you divide FCF by no. of shares. You get the Free Cash Flow per share. This is similar to dividing Net Profit by the no. of shares to get the EPS.

And finally, you divide the FCF per share by the stock price to get the FCF yield. This is similar to EPS divided by stock price to get the earnings yield, the inverse of the all-famous PE ratio. So we all know, the higher the earnings yield, the better, bcos it means more return of investors. Similarly the higher the FCF yield means more money back to investors.

Empirically FCF yield of 5-8% would indicate that the co. is quite good in terms of managing its cashflow and capex. If you get lucky you may find co.s with 10-12% FCF yield. What this means is that this business keeps churning out cash and yet you need not invest in a lot of new stuff to keep it going. This is the kind of businesses that value investors like. See's Candy would be an example that Buffett would place here. In Singapore, I think Vicom would be a good example. No. of cars keep increasing, but not much new investment needed to check more cars.

Sadly, I would guess that 30-40% of all listed co.s would have a negative free cash flow yield, bcos most businesses require a lot of capex just to keep going. The prime example would be semiconductor and/or tech businesses. Every few yrs, technology advances and companies just have to keep investing just to stay competitive. 6" wafers to 8" then to 12". Everytime to inch size changes, all the eqmt have to change. Is it a wonder why Chartered cannot make money?

So that's FCF yield, a good indicator of whether the co. is good or bad at generating cashflow for investors. But it's quite troublesome to calculate this and usually stock screens don't have this ratio easily available although it's on Bloomberg.


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8percentpa said...

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SG Money Mind said...

Have you ever looked at Cash flow statements of finance companies? I found it difficult to read them.