Intelligent Investing Using The “Free-Cash-Flow-Yield” Strategy

In the pursuit of seeking out the most undervalued stocks, it is surprising how many otherwise intelligent investors tend to default into the least-effort route of focusing purely on ‘technical analysis’ (reading chart patterns & signals) as a sole basis to make trading decisions. In so doing, the ‘fundamental’ values within the stocks they are trading, are invariably overlooked. That’s a mistake, and one which, with a little discipline, and a few minutes of time commitment, can be avoided.

Investing in markets based purely on chart-patterns & technical signals, can in some cases (especially in high volume/liquid markets) allow for improved ‘timing’ of entries and exits, but unnecessarily adds significant risk by ignoring the ‘qualitative’ aspect of the companies individuals are investing in.

The first priority of a fully-integrated strategy should be to produce and maintain a list of high quality, fundamentally strong companies, and only then, apply technical analysis to time entries/exits into and out of these core universe of selected businesses. By maintaining a ‘watch-list’ of the most ‘undervalued’, fundamentally superior stocks, using a few simple, finely tuned metrics, investors are in a much better position to profit from these select group of pre-qualified stocks using. Only at this point (once a shortlist of qualifying stocks – or universe – is produced) should an investor apply ‘timing’ tools, such as (but not limited to) technical analysis.

Whenever I look for a company to invest in, I make it a rule to ‘initially’ focus only on ‘fundamentals’. The key metrics I need to see, which instantly tell me whether a company is worthy of trading (or not) include:

(1) Positive revenue growth year-on-year (compares current quarter to the same-period quarter in the previous year).

(2) Positive operating income growth (or EBIT) year-on-year.

(3) Positive operating profit ‘margin’ growth year-on-year.

(4) Balance sheet total-assets-to-total-liabilities ratio above 1.0.

(5) Strong free-cash-flow-to-enterprise-value yield above 10% (more on this further below).

From the results, all financial sector businesses are removed, as well as all non-US listed companies, and companies with a market-cap of less than US$30 million. The information for all of the above are readily available via a number of free financial portals, including both Google Finance and Yahoo Finance. At present, I am in the process of developing a dedicated market screener, which takes these five fundamentals (as well as an additional 84 key metrics and ratio’s), to seek out ‘qualifying’ companies, auto-updated each day. This will be launched on my free screening site tradepilot.com in late 2013.

One of the core metrics I utilize (rule 5 above), to fine-tune the fundamental side of my analysis, is to measure the ‘free-cash-flow’ relative to the ‘enterprise-value’ of a company. The process begins by screening an initial universe of around 6,500 US stocks, listed on the NYSE, Nasdaq, and Amex, in order to isolate only those companies with a minimum free-cash-flow-yield of 10%. This is calculated by dividing a companies free-cash-flow by the enterprise-value, then converting the result to a percentage. Both the ‘free-cash-flow’ and ‘enterprise value” data points are readily available for most all US stocks, via Yahoo Finance, under ‘key statistics’ (click here for an example snapshot)…

The enterprise-value (EV) is a more accurate version of the commonly used ‘market-cap’. EV measures the true value of a company, from the perspective of a potential buyer of the business. By taking the market capitalization value of a business, then adding the debt, and subtracting the total cash, you get a more exact reflection of what the business is genuinely ‘worth’, and more crucially, what a potential buyer would consider paying to acquire the business. Think about this… a potential buyer of the company would not pay the actual market cap, but would have to also pay for any debt the company has outstanding, minus keeping any cash. In many companies the EV is fairly close to the market-cap, but there are instances where there can be a significant difference (eg., when a company holds excessive cash on the balance sheet).

While the EV provides a valuable indicator of the true ‘worth’ of a business, the free-cash-flow (FCF) provides an indication of the true ‘earnings’ power of the business. The FCF is a more superior, accurate reflection of a company’s ability to generate cash (real, booked profits from actual core operations), than the commonly presented ‘earnings’ data regularly reported within the financial press/media. Net earnings (and the EPS) are flawed metrics, subject to manipulation and bias by management who are more motivated and pressured to show good results, rather than exhibit the true operational integrity of a business. There are numerous metrics professionals utilize instead of the ‘net earnings’. These include ‘operating-income’, or similarly, ‘earnings-before-interest-and-tax’ (also known as EBIT), and of course, the ‘free-cash-flow’. All three metrics provide for a more accurate measure of the companies’ earnings than the commonly quoted net earnings and earnings-per-share (EPS). The best of these metrics, in my opinion, is the ‘free-cash-flow’.

With regards to the free-cash-flow metric, note, that this figure is also readily available (just like the enterprise-value) for any US listed stock, via Yahoo Finance, under ‘key statistics’. Armed with the FCF value and the EV value, an investor can quickly, and accurately measure the ‘percentage free-cash-flow yield’ a company generates, by dividing the free-cash-flow (FCF), by the enterprise-value (EV), multiplied by 100. To grasp this method, below are a couple of examples…

Looking at this in simple terms, assume you are in the market to buy a running business. You look at business “A” for which the owner wants to be paid $70,000 (the ‘price’). On it’s books, the company owes money, to the tune of $40,000 (‘debt). On the plus side, the company also holds some cash reserve of $15,000 (‘cash’)…

The first task is to calculate the EV. So, you do a quick calculation, and see that, in order to acquire the business, you would need to pay the owner his $70,000, add to this the debt which you are taking on, amounting to $40,000, and keep the cash already on the books, totaling $15,000. Therefore, the total ‘true’ cost to acquire the business, better known as the “enterprise-value” is $95,000 (that is $70,000 price ‘plus’ $40,000 debt ‘minus’ $15,000 cash).

Next, you study the companies accounts and see the pure, free-cash-flow generated in the business, which amounts to $18,000. From this data, you see that, for company “A”, the FCF/EV is 0.1894 ($18,000/$95,000). In other words the true percentage ‘yield’ (or the free-cash-flow-yield) is precisely 18.94%. All things equal, for your investment of $95,000, you can expect an 18.94% return.

Another example. You look at another competing business in the same industry, company “B”, for which the owner wants to be paid $110,000 (the ‘price’), plus the debt which the business owes, to the tune of $75,000 (the ‘debt’). In it’s books, the company also holds some cash reserve of $12,000 (the ‘cash’). So again, you do the same simple math, to discover if company “B” offers better value proposition…

You see that, in order to acquire the business, you would pay the current owner her $110,000, add the debt, amounting to $75,000, and keep the cash, totaling $12,000. The net cost to acquire the business (the “enterprise-value”) is $173,000 (that is $110,000 price ‘plus’ $75,000 debt ‘minus’ $12,000 cash).

Once again, you look at the company accounts and see the pure, free-cash-flow generated in the business, which amounts to $37,000. From this data, you punch in the numbers and see that, for company “B”, the FCF/EV ratio is 0.2138 ($37,000/$173,000). In other words the true percentage ‘yield’ (or the free-cash-flow-yield) is 21.38%. All things equal, for your investment of $173,000, you can expect a 21.38% return.

Based purely on these metrics (always subject to further analysis and due diligence), company “B” looks to offer a better value investment opportunity (more ‘undervalued’, by offering a higher ‘yield’) than company “A”.

Objectively, the free-cash-flow-yield removes much of the defect and questionability inherent in the commonly viewed P/E ratio, and provides a more transparent, mature measurement, from within which individuals can more accurately evaluate equity investments. Moreover, the ‘comparisons’ of free-cash-flow-yield between various competing businesses operating within the same industry, provide an excellent starting point for potential investing ideas when you are looking to ‘pick’ specific stocks within a specific industry or sector.

The free-cash-flow-yield, is the metric I prefer to utilize in the fundamental side of my research (rule 5), in order to find qualifying businesses, before applying any technical analysis. If this is not available (eg., hard to find EV figure), I instead use the ‘operating-income-to-market-cap’ (which I call ‘operating yield’) or the ‘EBIT/market-cap’ (‘earnings-yield’ based on EBIT). Any one of these three key metrics, applied to a list of companies operating within the same industry, delivers valuable insights into the specific companies I want to invest in, far superior to looking at the commonly touted P/E ratio.

Added to this (optional), investors can implement a fully hedged long stock/short S&P pairs trading strategy which wagers on the undervalued stock outperforming the S&P index (overall market) without anxiety about market direction.

To summarize, no matter which method you utilize towards seeking out potential stock investment opportunities, be it technical analysis, fundamentals, or a ‘mix’ of the two, it is a good idea to get back to the basics, the nuts and bolts of the ‘operational performance’ (FCF), relative to the ‘true worth’ (EV), of a business, as expressed by the simple-to-calculate, and demonstrated free-cash-flow-yield metric, in addition to the other four rules (sales growth, operating income growth, operating margin growth, assets-to-liabilities ratio). Once a universe of stocks is established (and re-screened/updated regularly, preferably daily), this is the point where market timing (such as technical analysis) can play it’s role…

Investing in a company, whether short, medium or long term, is no different to buying into a business, which is effectively, precisely what you are doing. As an investor, you need to know what profits are being generated from the ‘operation’ of the core business. If the business generates $50m free-cash-flow, and the enterprise-value is quoted at $800m, then the yield is 6.25%. By comparing this to other businesses within the same industry, you will begin to identify potentially undervalued and overvalued businesses. These simple metrics, more often than not, are the very starting point for evaluating potential mergers & acquisitions.

Wishing you every success in your trading… and good spirit…

Shiraz Lakhi – Self Directed Investor/Entrepreneur

15 Responses to Intelligent Investing Using The “Free-Cash-Flow-Yield” Strategy

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  14. jay why says:

    interesting article.
    i use the same metrics. i have two questions :
    - you mention a 6.25% as a normal free cash flow yield for us company. how do you achieve this number ? can you provide me with your source ?
    - a source as the free cash flow is yahoo!finance according to you; i have checked the website but it looks like they mention the “levered free cash flow”. so it is the “free cash flow to equity”;
    shouldn’t we use the “free cash flow to the firm” ? ie the free cash flow before interest payment. that way it is consistent to divide it by the EV and not by the equity.
    thanks in advance for your answers

  15. Great Article.

    Conventional wisdom would have you believe that investing during times when real estate is rapidly appreciating is the best way to accumulate wealth. I disagree. I think that when real estate is rapidly
    appreciating, it is a sign that there is a great disequilibrium in the market. Investing for appreciating is a double edged sword because you have no control over the market and therefore, you can not rely on the returns generated by your investment. I believe that investing for reliable cash-flow in non-volatile markets is the best way to accumulate wealth. After all, if you have $20,000 invested at 11% for 22 years and only let your initial deposit compound, the ending result is staggering:$222,451.24. Why is it that less than 10% of all americans have this amount in their retirement account? Because they invest for appreciation,whether it be stocks or real estate.

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