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(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

Generating cash from assets is the fundamental purpose of any business. Free cash flow - the cash left over after replacing or maintaining the asset base - is what allows a company to provide shareholder returns through growth investments, paying a dividend, or buying back stock. We covered how to calculate free cash flow in a recent article, but how can we put it to use directly to find the stocks of companies trading at low valuations against the free cash they generate?

Enter the free cash flow yield metric.

The Free Cash Flow Yield Calculation

Most investors focus on stock price value based on earnings-focused multiples, such as the price-to-earnings (P/E) ratio. Magic Formula® Investing, the strategy we follow, uses a slight variation, flipping the P/E ratio around to E/P (better known as earnings yield), and making a few modifications to focus only on business results and not non-operating factors like interest and tax payments.

However, it is just as easy to use free cash flow in place of earnings to calculate valuation. We could replace P/E with P/FCF:

Price-to-Free Cash Flow Ratio (P/FCF): Market Capitalization / Free Cash Flow

However, we can do even better by using Joel Greenblatt's modifications to P/E. First, instead of just using Market Capitalization, we can replace it with Enterprise Value, which rewards a company for having net cash (and punishes for a lot of debt). And then, we can flip the ratio into a yield percentage, as this gives us an easier comparison to other asset returns (like bonds or treasuries):

Free Cash Flow Yield = Free Cash Flow / Enterprise Value

Voila, the free cash flow yield calculation!

Putting Free Cash Flow Yield to Use

Now that we've covered why we should use it in lieu of P/E or earnings yield, and how to calculate it, let's put free cash flow yield to use in ranking the current 50 Magic Formula stocks over $50 million market cap (from the official screens). We know from the strategy's methods that these should already be cheap stocks of great companies, but perhaps applying the above calculation could shed some light on some overlooked investment candidates. Note that current high yield corporate bonds yield about 6.2%, 30-year treasuries yield about 3.7%, and the S&P 500 earnings yield is roughly 7%.

1) Enzon Pharmaceuticals Inc (NASDAQ:ENZN) - 38.99% FCF yield
2) Cirrus Logic Inc. (NASDAQ:CRUS) - 29.50%
3) RPX Corp (NASDAQ:RPXC) - 26.43%
4) USA Mobility Inc (USMO) - 20.27%
5) Columbia Laboratories Inc. (NASDAQ:CBRX) - 19.76%
6) Strayer Education Inc (NASDAQ:STRA) - 18.84%
7) United Online Inc (NASDAQ:UNTD) - 18.62%
8) PDL BioPharma Inc (NASDAQ:PDLI) - 18.12%
9) Cornerstone Therapeutics Inc (NASDAQ:CRTX) - 15.93%
10) Great Northern Iron Ore Properties (NYSE:GNI) - 15.54%
11) Apple Inc (NASDAQ:AAPL) - 13.25%
12) Inteliquent Inc (NASDAQ:IQNT) - 13.25%
13) Smith & Wesson Holding Corp (NASDAQ:SWHC) - 13.14%
14) Cisco Systems Inc (NASDAQ:CSCO) - 12.94%
15) ITT Educational Services Inc (NYSE:ESI) - 12.52%
16) Apollo Group Inc (NASDAQ:APOL) - 11.69%
17) Engility Holdings Inc (NYSE:EGL) - 11.45%
18) Myriad Genetics Inc (NASDAQ:MYGN) - 11.09%
19) Chemed Corp (NYSE:CHE) - 10.88%
20) Dynamics Research Corp (NASDAQ:DRCO) - 9.93%
21) Ebix Inc (NASDAQ:EBIX) - 9.77%
22) Microsoft Corp (NASDAQ:MSFT) - 9.56%
23) USANA Health Sciences Inc (NYSE:USNA) - 9.15%
24) Questcor Pharmaceuticals Inc. (QCOR) - 9.01%
25) Dice Holdings Inc (NYSE:DHX) - 8.69%
26) CA Inc (NASDAQ:CA) - 8.58%
27) Herbalife Ltd (NYSE:HLF) - 8.50%
28) Valassis Communications Inc. (NYSE:VCI) - 8.50%
29) CACI International Inc. (NYSE:CACI) - 8.42%
30) Coach Inc. (NYSE:COH) - 8.42%
31) PetMed Express Inc (NASDAQ:PETS) - 8.42%
32) Buckle Inc. (The) (NYSE:BKE) - 8.00%
33) Northrop Grumman Corp (NYSE:NOC) - 7.56%
34) Unisys Corp (NYSE:UIS) - 7.36%
35) Activision Blizzard Inc (NASDAQ:ATVI) - 7.34%
36) Deluxe Corp (NYSE:DLX) - 7.18%
37) Weight Watchers International Inc. (NYSE:WTW) - 7.11%
38) Performant Financial Corp (NASDAQ:PFMT) - 7.00%
39) GameStop Corp. (NYSE:GME) - 6.89%
40) Raytheon Co. (NYSE:RTN) - 6.76%
41) Liquidity Services Inc (NASDAQ:LQDT) - 6.58%
42) Sturm Ruger & Co Inc. (NYSE:RGR) - 6.10%
43) Altria Group Inc (NYSE:MO) - 6.05%
44) Lorillard Inc (NYSE:LO) - 5.72%
45) Booz Allen Hamilton Holding Corp (NYSE:BAH) - 4.81%
46) Gentiva Health Services Inc (NASDAQ:GTIV) - 4.75%
47) Lender Processing Services Inc (NYSE:LPS) - 4.32%
48) Vector Group Ltd (NYSE:VGR) - 1.99%

Left out are Argan (NYSE:AGX), which is cash flow negative over the past 12 months, and FAB Universal (NYSEMKT:FU), which is a shady Chinese reverse merger.

As always, investors should do their own research before buying. For example, firms like Strayer and United Online seem to have perpetually declining revenues and cash flows. And several of these stocks actually have yields below the market average! On the other hand, blue-chip tech firms like Cisco and Apple are trading at significant discounts to the market based on their free cash generating ability.

Disclosure: I am long AAPL, PFMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Ranking 50 Stocks By Free Cash Flow Yield