Nov 25, 2013

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 Greenblatts 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 weve covered why we should use it in lieu of P/E or earnings yield, and how to calculate it, lets put free cash flow yield to use in ranking the current 50 Magic Formula stocks over $50 million market cap. We know from the strategys 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%.

2) Cirrus Logic Inc. (CRUS) — 29.50%

3) RPX Corp (RPXC) — 26.43%

44) Lorillard Inc (LO) — 5.72%

45) Booz Allen Hamilton Holding Corp (BAH) — 4.81%

46) Gentiva Health Services Inc (GTIV) — 4.75%