A company’s free cash flow is an important measure that shows how much capital the business has to pay down its debts, reinvest in the company, or return to shareholders through dividend payments.
For public companies, investors may take their assessment one step further and analyze your free cash flow in relation to your market capitalization.
Doing so not only helps them gauge how effectively you’re generating free cash flow but also the potential returns they could expect from purchasing your company’s shares.
Continue reading below as we define what free cash flow yield is, how to calculate it, and explain what you and investors can take away from your free cash flow yield.
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What is Free Cash Flow Yield?
Free cash flow (FCF) yield is a financial solvency ratio that measures your free cash flow in relation to your market capitalization.
In this case, market capitalization refers to the stock market value of a business, which only applies to companies that are publicly traded.
Free cash flow is an indicator of how much cash your business has left on hand after taking care of operational costs, so this value helps show investors how much cash could be reinvested in the business or deployed back to them through dividends or interest.
Comparing the amount of free cash flow you generate against your market capitalization gives investors a way to compare how efficiently you use capital in relation to the value of the business and their own investments in your shares.
Since your market capitalization is based on the current share price, it’s a value that is constantly fluctuating as your shares trade up or down on the stock market.
Because of this, both your market cap and your FCF yield provide just a snapshot of your financial health at a given time and showcases your ability to generate free cash flow.
Related: Free Cash Flow Margin
How to Calculate FCF Yield
You can calculate your free cash flow yield by dividing free cash flow per share by your market capitalization per share.
Here is the simple formula to calculate FCF yield:
FCF Yield = Free Cash Flow per Share / Market Capitalization per Share
You calculate free cash flow with items from the cash flow statement using this formula
FCF = Cash Flow from Operations – Capital Expenditures
To find the FCF per share, simply divide the free cash flow value you calculated by the number of shares outstanding.
As a reminder, your market capitalization is the total number of shares outstanding, multiplied by the current share price, which you can calculate with the following formula:
Market Capitalization = Shares Outstanding * Current Share Price
So, finding the value of the market capitalization per share is simply whatever the current share price is.
FCF Yield Example
Let’s say that a company generated cash flow from operations of $136,000 for the quarter and spent $24,000 on capital expenditures to purchase some new machinery.
They have 108,000 shares outstanding, which are currently trading at $17.60 per share.
Using these values, we can first calculate the free cash flow they generated during the last quarter by subtracting their capital expenditures from their cash flow from operations:
$112,000 = $136,000 – $24,000
Then, we can find their FCF per share with the following calculations:
$1.04 = $112,000 / 108,000
Again, the market capitalization per share is just the current price per share, which is $17.60 in this case.
So, to find the FCF yield, we need to divide the FCF per share by the share price, as shown below:
5.9% = $1.04 / $17.60
In this example, the company’s FCF yield was 5.9%. In other words, for every $1 invested into the company’s shares, it generates almost $0.06 in free cash flow.
Why Should Businesses Care About FCF Yield?
As a publicly-traded company, driving value for your shareholders is an important aspect of how you make decisions and deploy your capital.
To investors, generating a good amount of free cash flow is seen as a healthy indicator for your business. It means you have the capital to reinvest back into the company, pursue growth opportunities, pay down your debts, or pay out dividends to shareholders–all of which add value.
But, taking the free cash flow value in relation to share price provides another layer for analysis that helps determine the solvency and profitability of your company.
In other words, if you’re able to generate a good amount of cash flow per share in relation to your share price, it’s a good sign of how efficiently you are able to generate excess capital that benefits the business and your shareholders.
What Does Your FCF Yield Say About Your Business?
You can interpret your FCF yield to see how much free cash flow your business generates for every dollar invested into your shares.
As such, in general, the higher the free cash flow yield, the better. A higher value signifies that you have more cash on hand to use after taking care of your obligations to keep operations running smoothly.
On the contrary, a lower FCF yield would show that your capital is limited. You have enough to sustain your operations, but paying off your debts or paying out dividends to investors may not be feasible at this point.
Going one step further, a negative FCF yield would be caused by a negative free cash flow. Put differently, this means that you didn’t generate enough cash to cover your necessary operational expenses and capital expenditures.
Business leaders and investors will interpret a negative FCF yield as a sign that the business cannot sustain its operations, nonetheless return capital to its investors.
This can be expected by companies in the early growing stages as they invest heavily into their business through capital expenditures. However, prolonged negative free cash flow and FCF yield is typically a warning sign that the business is not generating enough cash to support itself.
Factors that Affect Your Free Cash Flow Yield
Given the various inputs to the FCF yield formula, there are a number of variables that can affect your free cash flow yield.
For one, how your shares are trading on the stock market plays a big role in determining your free cash flow yield.
All things considered equal, the lower your stock price is, the higher your FCF yield will be. On the other hand, if your shares are trading higher, it will dilute your FCF yield and cause it to be lower.
How much cash flow you use or generate from operating activities is also a core factor for determining your FCF yield, as well as how much you spend on capital expenditures.
Each of these variables can fluctuate throughout the quarter or the year. So, it’s important for both business leaders and investors to understand the different factors that drive FCF yield higher or lower as they evaluate the future prospects of the business.
Why Do Investors Care About FCF Yield?
From your FCF yield, investors can gauge how much free cash flow your business is generating per dollar they invest into your shares.
This can give them a better idea of how likely they are to recoup their investment through dividend payments or business growth and provides more clarity into the ROI that they can expect from investing in your company’s shares.
For example, a high FCF yield may indicate that a certain company’s shares are undervalued and that a company is generating a good amount of free cash flow in relation to a relatively low share price.
While investors will typically combine FCF yield with other metrics when analyzing an investment in a given company, this measurement provides unique insights and gives them a clear way to compare different companies against one another.
Investors can compare the FCF yield of your company versus your competitors or industry benchmarks to analyze the investment potential of your shares.
Start Measuring Your FCF Yield Today
Your FCF yield gives you a way to measure how efficiently your business generates free cash flow in relation to your market capitalization.
When you want to have better visibility into your business’s free cash flow and finances, use Finmark as your financial planning tool. You can access custom reports and real-time data that accurately reflect the financial health of your business to power more informed decision-making.
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This content is presented “as is,” and is not intended to provide tax, legal or financial advice. Please consult your advisor with any questions.
