Price-to-free-cash-flow and FCF yield

Price-to-free-cash-flow asks how much you are paying for each dollar of cash a company produces after paying for the investment needed to run and grow the business. Its mirror image, free cash flow yield, expresses the same thing as a percentage return on the price. Many investors like these measures because cash is harder to dress up than accounting profit, although they come with traps of their own.

The formulas

Free cash flow (FCF) = operating cash flow - capital expenditures

P/FCF     = market capitalization / FCF
FCF yield = FCF / market capitalization = 1 / (P/FCF)

Operating cash flow and capital expenditure both come from the cash flow statement; see how to read a cash flow statement and free cash flow explained.

There is a second version used with enterprise value: unlevered FCF divided into EV, sometimes called enterprise FCF yield. It measures cash available to all capital providers, so it is the right match for EV, just as ordinary FCF after interest is the right match for market capitalization. Always check which version a source is quoting.

Example (illustrative numbers)

A company has a market capitalization of $10,000 million.

P/FCF     = 10,000 / 500 = 20
FCF yield = 500 / 10,000 = 5.0%

Suppose net income was $600 million, a P/E of about 16.7. The company's FCF is lower than its profit because it spends heavily on equipment. A P/E alone would make it look cheaper than the cash view does. Neither number is wrong. They answer different questions: one about accounting profit, the other about the cash left after reinvestment.

Why investors use it

• Cash pays the owners. Dividends, buybacks and debt repayment all come from cash, not from reported profit.
• Less affected by accounting choices. Depreciation schedules, provisions and some revenue timing matter less to cash than to earnings. Compare with operating cash flow vs net income.
• Works when earnings are distorted by large non-cash charges.
• The yield framing makes comparison with other returns intuitive: a 5% FCF yield means the business generated 5 cents of free cash for each dollar of market value. Unlike a bond coupon, that cash can grow or shrink, and it is not necessarily paid out.

How to read it

Rules of thumb:

• A lower P/FCF (higher FCF yield) means you pay less per dollar of cash, other things equal. But other things are rarely equal.
• Judge the yield alongside growth. A 5% yield on cash flow growing 10% a year is a different proposition from 5% on cash flow that is shrinking.
• Look at several years. A single year can be unusually high or low, so a multi-year average is more reliable.
• Compare within a sector, since capital intensity differs widely across industries.

Common mistakes and limits

• Lumpy capital spending. FCF is high when a company pauses investment, and low when it builds a new plant. Neither year is typical. Distinguish maintenance spending from growth spending; see capital expenditure.
• Working capital swings. Collecting from customers early, or delaying payments to suppliers, can flatter operating cash flow for a period without reflecting lasting economics.
• Stock-based compensation. It is a non-cash expense added back when computing operating cash flow, so FCF ignores the dilution that pay in shares creates. Compare FCF with and without it, and watch the share count; see stock-based compensation and dilution.
• Definition differences. Some sources subtract capitalized software, acquisitions or lease payments; others do not. When two FCF figures disagree, this is usually the cause.
• Financial companies. For banks and insurers, cash flows from lending and deposits run through operating activities, so FCF is generally not meaningful.
• Negative FCF. A growth company may burn cash. That makes P/FCF undefined, so consider whether the cash is being invested productively and whether financing is secure.

FCF yield and dividends

Dividends should come from free cash flow over time. If a company pays out more than it generates, it must borrow, sell assets or issue shares to cover the gap, which is rarely sustainable. See the dividend payout ratio for the earnings-based version of this test.

Where to see it on StocksXray

P/FCF is one of the three multiples in the peer-multiples model used for fair value, applied using the sector median. Separately, stock pages carry a red flag when dividends exceed free cash flow. Read the methodology page for how the models are blended.

Key takeaways

• P/FCF is market cap divided by free cash flow; FCF yield is the inverse, expressed as a percentage.
• FCF is operating cash flow minus capital expenditure, though definitions vary.
• Smooth out lumpy capex and working capital swings by looking at several years.
• FCF ignores the dilution from stock-based pay, so check the share count too.