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Free-Cash-Flow-Yield. A better way to value common stock

|Includes: GPS, Microsoft Corporation (MSFT)
AlphaNinja – I constantly refer to FCFY, or “Free Cash Flow Yield,” as my preferred method of valuing a company -->> so I thought I’d explain in greater detail why I use it so much. I’m long-winded here so please bear with me – the important stuff is at the end.

The most widely used stock valuation techniques have proved to be very flawed over the last year or so.


Maybe the most used valuation method, the PE ratio is simply the price of a stock, divided by the per-share earnings of that stock/company. A $10 stock that earns $1 per share has a PE of 10, and is cheaper than a $10 stock that earns 50cents, which would have a PE of 20. Analyst and investor price targets often use PE ratio’s based on

-the “industry average” (technology PE ratio’s high, oil majors low, etc.)
-historical discount/premium to the “market PE”, or the PE of the S&P500
-the company’s historical mean or median PE
-relation to the company’s growth rate (higher growth = higher PE)

People lost a LOT of $$ recently thinking stocks were cheap based on “historical” PE ratios, or PE ratio’s tied to earnings growth expectations. The whole problem is that PE selection is incredibly arbitrary.


The interesting thing about DCF valuations is that in my opinion, they’re designed to inflate the value of a company; which is why they’re so popular among ibankers pitching companies to be LBO’d, or for various refinancing deals, or for a company to put itself on the block.

The two main steps in a DCF valuation both have problems. First is creating the earnings and cash flow model, usually 10-15 year projections. If you look at most DCF models over the last few years, you’ll notice gently increasing Revenue, Earnings and Free Cash Flow, and gently decreasing CAPEX (Capital Expenditures, which reduce Free Cash Flow). These projections are simply too manipulatable (granted, people use “sensitivity analysis” to account for various scenarios, but the folly of predicting earnings 15years out remains). Then one has to guess earnings growth into “perpetuity,” as it that can be done.

The second and more troubling aspect of the DCF model is coming up with the “cost of capital.” This is the “hurdle” rate, or a rate that is high or low depending on the riskiness of the cash flows. I can’t go into too much detail here because I’ll write for days, but for one thing DCF valuations usually give companies a lower discount rate if they employ larger amounts a debt -> an absurd concept that I’ll detail another time. Suffice it to say that Microsoft, who can borrow money at 3-4%, should not have a 7-9% cost of capital b/c they have a debt-free(almost) balance sheet. Low “cost of capital” thanks to debt led people to inflate the values of over-levered companies with good cash flow, like tower companies (AMT, CCI).


Finally, on to my preferred method of equity valuation. Since I don’t know how to pick the right PE for a company, and I don’t trust anyone to model earnings 15 years in the future (not to mention my hatred of CAPM, which is the way equity “cost of capital” is computed) -> I need a better way.

FCFY is simple. It compares what you could buy a company for, and what it would produce in income for you – income being Free Cash Flow. If company A has a market value of $100million and earns $13million in Free Cash Flow annually, its FCFY is 13%. Whether that is attractive to you or not is debatable, but it's clear.

FCFY makes comparisons with other asset classes easier, but I think the best way to figure out an attractive FCFY (higher the better, remember – if you put your money somewhere you want the best return) is to look at what the company’s borrowing costs are. As I said above, Microsoft can borrow for 3-4%, so that company should NEVER yield 3-4times that much in FCFY, as it has recently and why it was a good buy then.

The main example I’ll use here is The Gap (NYSE:GPS). The 2010 expected Free Cash Flow target has been and remains about $1billion. Below is a chart of Gap’s FCFY and its stock price (another kindergarten-quality chart from AlphaNinja!). I “net out” or subtract cash-per-share for Gap, because an acquirer would be getting that cash if they purchased the company. I also adjusted back for last year’s Free Cash Flow per share, so as not to use 2010 numbers. Anyway – the chart shows that purchasing GPS shares when the FCFY yield was 7% was a bad choice, as it coincided with the stock’s 52-week highs. If you wait for a more “juicy” yield in the 14-15% range, you’re sitting on a couple dollar per share profit on your stock purchase. And if you are very selective and wait for the fat yield, you look like an all-star stockpicker, buying GPS shares under $10 when FCFY was near 19%!!

A caveat – deciding what is an attractive FCFY might sound as arbitrary as picking PE ratio’s, but at least it’s a clear yield to think about what you’re getting for your money. It also uses Free Cash Flow instead of earnings – a company may report decent earnings, but cash flow may be completely consumed by capital expenditures.

Another caveat - FCFY works best with low-debt companies. You'll find enormous FCFY % out there, but often your next step will be guessing how close these companies will come to breaking their debt covenants and flirting with insolvency. These yields are high for a reason, so watch out.

No valuation measure is perfect – but using FCFY has been very profitable for me, and I think it is a better way to pick stocks going forward.