Posted in Finance, Accounting and Economics Terms, Total Reads: 418
Definition: Free Cash Flow Yield
It is an indicator of the overall return expected per share. It is the ratio of free cash flow the company is expected to earn per share to the current market price per share of the company (or in other terms, the company's total cash flow divided by its market cap)
Free Cash Flow Yield = Free Cash Flow per share÷Current Market price per share
It is similar to earnings yield, except it deals with cash flow instead of earnings, and is used mainly by individuals who believe cash flows to be a true indicator compared to earnings. Usually, lower the value of this ratio, the less attractive the company is and vice versa. The reasoning behind this is that investors like to pay as less as possible for as much earnings a company can give back to the investors. A company may use accounting tricks to fake its earnings, but cash flows are harder to fake - the company has either a cash inflow or a cash outflow. The true value of a company is simply the discounted present value of all future cash flows, according to finance theory. So, cash flows are evidently a better measure of business performance than earnings. Free cash flow is a step further, as it reduces the costs the company pays to keep the operating expenses of the business.
Free cash flow yield is a valuable tool to gauge businesses which have matured over the years, companies such as Anheuser-Busch or Coca-Cola. With their large market shares, and sluggish demographic growth in their key markets, neither company is likely to experience tremendous future growth. Their industries have intense competition, as they continuously battle their leading competitors -- Miller and PepsiCo respectively, for a larger share of an existing pie. Free cash flow and its yield are comparatively easier to calculate with such companies, which are capable of a reasonably stable rate of growth.
But in cases of smaller, faster growing companies, the market itself may be growing, and a fast-moving company, like Apollo Group in education has an opportunity to grab a large piece of it. In cases like these, free cash flow yield may not be the best practice to judge the performance of companies, since they're most likely attracting capital into the business to help fuel expansion.