I was re-watching the interview Joel Greenblatt recently did with CNBC at the Ira Sohn Conference and an interesting thing started to develop, I started to notice Joel Greenblatt mentioned free cash flow yield more often than the Magic Formula’s earnings yield (specifically, the third video down). I’ve personally used free cash flow yield for quite some time now and in my opinion, it is a perfect companion to the magic formula’s earnings yield.
What is free cash flow yield?
According to Investopedia.com:
An overall return evaluation ratio of a stock, which standardizes the free cash flow per share a company is expected to earn against its market price per share. The ratio is calculated by taking the free cash flow per share divided by the share price.
Free cash flow yield can be used like the magic formula’s Earnings Yield in which you can compare the yield versus other stocks and assets such as a bond or U.S. Treasury. In a environment like today in which Treasuries offer no yield ( 3.17% on a 30 YR U.S. Treasury), I like to stick to Joel Greenblatt’s minimum hurdle of 6%.
How to Calculate Free Cash Flow Yield
As you can see from the formula above, calculating Free Cash Flow Yield is not too complex and does not require any advanced algebra or greek letters. As a matter of fact, the free cash flow yield calculation involves 3 items:
- Free cash flow
- Number of shares outstanding
- and the Current Market Price Per Share
To calculate free cash flow yield I like to use Morningstar’s “Key Ratios” page which looks something like this. For this example, I will calculate the free cash flow yield of Pepsi (PEP),which currently trades at $64 (which will be our denominator).
Next, we need to calculate the numerator or free cash flow per share. According to Morningstar, for the past twelve months or trailing twelve months (ttm), Pepsi has generated free cash flow of 5.605 billion dollars. Pepsi also currently has 1.597 billion shares outstanding. In other words, Pepsi has free cash flow per share of $3.51 (5.605/1.597).
We divide that number by the current stock price and Pepsi currently has a free cash flow yield of roughly 5.5%. Our math looks something like this:
$3.51/ $64=5.48%
Not exactly a compelling bargain right? It doesn’t meet our minimum hurdle rate of 6%.
So what do we do? Assuming we love Pepsi’s business, we simply sit and wait until it trades at a higher free cash flow yield. Which brings me to my next question?
What is a good free cash flow yield?
The higher the better. I personally, use a 10% hurdle rate.
Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks (Wiley Finance)
Found Money: Simple Strategies for Uncovering the Hidden Profit and Cash Flow in Your Business
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