For long term investors, free cash flow is a great stock valuation tool.
Value investors use free cash flow to calculate Free cash flow yield (FCF Yield).
Experts say that use of free cash flow yield is a better valuation tool than Price Earning ratio (P/E).
Why cash flow is such a valuable valuation tool?
Cash flow management is most critical in managing the day-to-day operation of business.
Investors had been greatly using valuation indicators like P/E ratio (earning yield) & PEG ratio (EPS growth rates) etc in the past.
Now, the trend to use of a new valuation tool in form of free cash flow yield is becoming popular.
Use of free cash flow yield as a value indicator is very effective. In a way free cash flow is a ‘true value indicator’.
Free cash flow indicator is a true value indicator because it is that parameter that is difficult-to-manipulate.
Free cash is nothing but the amount of cash balance after payment of all dues (vendor payments, pays and perks of employees, operating expenses, loan payments, capital expenditure etc).
Cash comes in the bank account of company when payments are made by customer. Cash moves out of the bank account when payments to vendors, utility bills etc.
In short-term, cash flow is the most important parameter of company that managers strives very hard to manage. This is called as cash flow management.
If sufficient cash is not flowing-in the company then it will not be possible to make due payments. If due payments are not paid for prolonged time it is a bad sign, indicating company closure.
Hence top managers does cash flow management very closely.
If cash-in is not proper then management may opt for bank loans. Objective is to never allow cash flow to run in negative. A positive cash flow ensures smooth running of companies operations.
Cash flow is like a blood flowing in the veins of companies, if blood flow stops it indicates immediate death.
Free cash flow formula is not very difficult to use. Calculation of free cash flow can be done by this formula:
|Free cash flow = Net cash from operating activity – Capital Expenditure (CAPEX)|
Free cash flow is equal to net cash generated from operating activities and subtracting it with capital expenditure.
Both ‘net cash generated by company from operating activity’ and ‘capital expenditure’ can be obtained from ‘cash flow statement’ of company. A typical cash flow statement looks like this:
|Net Profit after Tax (PAT)||Rs 8700 Crore|
|Net cash from Operating activity||Rs 5700 Crore|
|Net cash from Investing activity (CAPEX)||Rs (-) 0850 Crore|
|Net cash from Financing activity||Rs (-) 4600 Crore|
|Net Cash in Bank (Net Cash and Cash Equivalents)||Rs 250 Crore|
|Free Cash Flow||Rs 4850 Crore|
Note: While the company is declaring Net Profit After Tax (PAT) as Rs 8700 Crore but the free cash available with company is only Rs 4850 Crore. This is the reason why value investors rely more on free cash generated by company rather on the companies PAT.
Another important indicator visible in cash flow statements is called as “Net cash and cash equivalents” which in simple terms can be understood as ‘net cash in companies bank account’. A positive cash here means the company is generating enough cash to pay all its dues.
Sometimes it happens that when companies are investing heavily to fund its future growth (CAPEX) the company may have negative free cash flow.
Like Price Earning Ratio (P/E) can be used to calculate the earning yield (inverse of P/E), free cash flow can be used to check the actual worth of the company (by free cash flow yield). Free cash flow yield can be calculated by dividing free cash flow by market capitalization.
Utility of Free Cash Flow Yield
Earning yield is a good value indicator of a company.
But free cash flow yield gives a more realistic picture of the true valuation of company.
Suppose you have bought shares of company that is currently trading at dividend yield of 4% per annum. As a value investors it becomes very important for your check if the company is able to pay the same level of dividends in future. You can do this by looking at its free cash flow. Suppose the companies’ dividend payout is 50% of its PAT (Rs 8700 Crore). Means the company is paying Rs 4350 Core in dividends. The free cash flow of this company is Rs 4850 Core. It means the company is paying Rs 4350 core out of its free cash of Rs 4850 core (90% of free cash flow).
In this situation, it is most likely that company will cut down its dividend payments in tough times. Value investors always value share in terms of its dividend payout. But it is equally important for investors to look at dividend payout consistency. Comparing dividend payout with free cash of company will give you a real picture of whether the present dividend payments can be sustained in years to come.
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