In value investing, everyone has their own methodology in deriving an intrinsic value for a company from DCF analysis to NAV calculations. What I personally use is FCF yield and will be talking about how one can use it. Moreover, if one analyses many of the superinvestors (Warren Buffett, Peter Lynch, Ken Fisher etc.) methodologies, many uses FCF yield as a key factor in analyzing a stock.
FCF is simply Net Cash Provided by Operating Activities minus Capital Expenditures. Theoretically, FCF is the amount of money a shareholder can take out of the company after paying for the essentials of the core business. Hence, FCF yield essentially is the yield for every dollar invested in the company
There are two ways of calculating FCF yield,
- FCF/Market Cap
- FCF/Enterprise Value
Personally, I prefer using the latter as Enterprise Value (EV) as it is a more accurate representation of a firm’s value (the theoretical takeover price). Furthermore, using EV, it punishes companies which takes on huge amounts of debt and rewards companies that are in a net cash position.
There are many ways of calculating EV, but I would just be focusing on the following two,
- Market Cap + Total Debt – Total Cash & Cash Equivalents
- Market Cap + Total Debt – Excess Cash
The first equation is pretty straightforward to understand. While for the latter, the key point would be excess cash. By deducting for the total cash & cash equivalents, it can lead to miscalculations as it is not realistic to assume that the company does not require to hold any cash to operate its core business. To calculate excess cash is as such,
- If Total Current Assets minus Total Cash & Cash Equivalents > Total Current Liabilities, it means that the amount of non-cash current assets is sufficient in settling for the current liabilities. Hence, excess cash in this scenario would be the total cash & cash equivalents.
- If Total Current Assets minus Total Cash & Cash Equivalents < Total Current Liabilities, it means that the amount of non-cash current assets is insufficient in settling for the current liabilities. Hence, excess cash in this scenario would be the total cash & cash equivalents minus the difference between the current liabilities and non-cash current assets.
Whether one uses the first or second method of calculating EV, is subjected to one’s discretion. This is because there are some companies (e.g. construction industry) that need to have a bonding company that requires them to hold a certain amount of cash on their balance sheets, whereas some might not. One could drop an email to the company’s IR to request for more information. Hence, the calculation of EV is pretty subjective.
After calculating the FCF yield, we compare it with the US corporate bond yield or 30-year treasury yield (data is all retrievable from Bloomberg markets website). The two bond yields represents what is the fair yield in the economy if we were to consider investing in assets deemed as almost no risk. FCF yield is comparable to how one uses the P/E ratio in valuing a company – difference is that FCF yield provides a better measure of a company’s performance.
Note: Using FCF yield alone to determine if a company is undervalued to invest in is insufficient. One still has to do the fundamental and qualitative analysis of a company to determine if the company is healthy and assess any potential risk it faces. FCF yield is only used as one of the indicators and a way in determining the fair value for a marker to selling.
Hope this is useful 🙂