The Free Cash Flow (FCF) Yield Shows Us When to Invest
One of my favorite financial metrics is free cash flow (FCF) yield.
FCF is the cash a company has left after deducting its capital expenditures in a given period.
FCF yield is what you get when you divide free cash flow by price. (Price equals market cap in the world of stocks.)
Many growth companies generate negative FCF yields. They put the money they generate back into growing the firm.
However, the bulk of the companies in the large-cap S&P 500 Index generate positive FCF.
In general, the more FCF a stock generates compared to its price, the better a value it is.
Today, there’s a lot of angst that this market is too expensive and is due for a pullback.
FCF boils through a lot of the noise to tell us where today’s market is. Read on to learn what it’s showing today…
Higher Free Cash Flow Is Better
Take a look at this chart of the S&P 500 (the white line) plotted against its historical FCF yield (in green) every quarter since 1990.
The higher the FCF yield, the better.
As you can see, the market was super cheap in 2009 based on this metric. At the end of the first quarter, the FCF yield of the S&P 500 was 11.2%.
But it wasn’t just the start of that year. Stocks were quite cheap again in the second quarter the next year (10.9%). After falling, the FCF yield returned to 9.5% in September 2011.
Stocks aren’t as cheap today as they were during the Great Recession.
As of March 11, the market’s free cash flow yield is about 5.4%.
Don’t let this fool you, though. It’s less than its highs, but this doesn’t mean the market’s expensive.
The valuations of the years 2007 through 2011 were the exception, not the norm.
From 1978 to 2018, the average FCF yield of the S&P 500 was 4.85%.
That means stocks today are generating more FCF than normal.
When stocks trade with a yield at or above that of today, they generate solid returns.
I went back and looked at all the times they did since January 1990. Here’s what they did next:
The positive returns that followed may soothe some of your worries.
This isn’t a guarantee, but it’s a great sign.
In the past, when companies are generating this much cash, they do well in the near future.
So, if you’re worried about the market’s future, use this as a guide. Based on historical FCF yield, stocks are reasonably priced.
Editor, Insider Profit Trader
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