The Power of Free Cash Flow Yield

May 2016

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The Power of
Free Cash Flow Yield

- Michael Mack, Portfolio Manager

Valuation metrics offer investors a simple way to assess a company’s worth by looking at its sales, earnings and cash flow. These metrics compare the company’s value to the market’s assessment of the company to determine if an investment is attractive. Let’s take a look at the most commonly used valuations and explore why we believe free cash flow yield is the most valuable of them all.

A wide variety of valuations

There are many valuation metrics for investors to use. So which is best? Let’s look at some of the common ones listed to the right. With the exception of free cash flow yield, a lower ratio indicates a more attractive investment. For example, a company with a share price of $29 and $1.80 in earnings per share over the last 12 months would have a price to earnings ratio (P/E) of 16.11. This company would be a more attractive investment than a company with a P/E of 18.86 ($33 share price and $1.75 earnings per share).

The flow of information

Putting aside the definitions, what do each of these metrics mean and what do they tell investors? Are all metrics created equal? According to Warren Buffett, they are not.

Common Valuation Ratio How Ratio is Calculated
Price to Book Price per Share
Book Value per Share
(Assets - Liabilities)
Price to Sales Price per Share
Sales per Share
Price to Earnings Price per Share
Earnings per Share
Price to Cash Flow Price per Share
Cash Flow per Share
Price to Free Cash Flow Price per Share
Free Cash Flow
(Cash - capital expenditures)
Free Cash Flow Yield Free Cash Flow
Enterprise Value
(Market Cap + Dedt - Cash)

“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.”
– Warren Buffett’s 2000 Annual Letter

As Buffett notes, free cash flow is the most important metric and other assessments merely serve as a guide to help determine free cash flow. The diagram below shows that each of these valuations builds on the information from the ones before, starting with book value and ultimately providing the most important and useful metric, free cash flow. 

The Power of Free Cash Flow Yield

More on Free Cash Flow

Now that we’ve established that free cash flow offers us the most insight of the available measures, let’s take a closer look at what it is, what it’s used for and why it’s important to investors.

What is Free Cash Flow?

Impact on a Portfolio

The Merrill Lynch US Quantitative Strategy team looked at how a portfolio built on each of these metrics performed over the past 30 years. Below, free cash flow yield (free cash flow/enterprise value) offered the investor the highest return and the fewest periods of negative returns. Going forward, there is no way to be sure that free cash flow yield will continue to provide the best returns. In fact, there have been market cycles where companies with high free cash flow yields have underperformed. Nevertheless, we believe there is a compelling reason to invest using free cash flow yield.

Valuation Strategies

(1/1/1986 - 4/30/2016)

Impact on a Portfolio

Chart Key:
FCF/EV: Free Cash Flow ÷ Enterprise Value
P/Free CF: Price ÷ Free Cash Flow
EV/EBITDA: Enterprise Value ÷ EBITDA
(Earnings before interest, taxes, depreciation and amortization)
Earnings Yld: Price ÷ Earnings
Forward Earnings Yld: Price ÷ Forward Earnings
P/CF: Price ÷ Cash Flow
P/Sales: Price ÷ Sales
P/B: Price ÷ Book Value
Reprinted by permission. Copyright © 2016 Merrill Lynch, Pierce, Fenner & Smith Incorporated (“Bank of America Merrill Lynch”). The use of the above in no way implies that Bank of America Merrill Lynch or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Pacer Advisors’ use of such information. The information is provided “as is” and Bank of America Merrill Lynch and its affiliates does not warrant the timeliness, accuracy or completeness of the information.

How to Invest in High Free Cash Flow Yield

So now that we’ve established that free cash flow yield is an important metric to consider, how can you use it? The Pacer Global Cash Cows Dividend ETF (GCOW) uses a free cash flow yield screen and a dividend yield screen to invest in 100 companies from the FTSE Developed Large-Cap Index. Since high dividends do not always mean quality or consistent dividends GCOW uses a high free cash flow yield to screen for sustainable dividend yield. It aims to provide a continuous stream of income and capital appreciation over time.

Learn more about how GCOW can help diversify your portfolio.

There is no guarantee dividends will be paid. A company’s ability to pay dividends may stop or be limited in the future.
The information presented here is not intended to forecast events or guarantee results. The strategies discussed are for educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategy will be effective.

This document does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Please consult with your financial advisor and tax advisor before investing.