Ever wondered what the best valuation metric to find value stocks is? Well, this post is the answer to your prayers. I’m about to show you why the free cash flow yield is the undisputed champion for this task, the theory behind it, and finally, how to implement a free cash flow yield stock screener strategy.
Why the Free Cash Flow Yield?
We are all familiar with the concept of value investing – buying shares that are “cheap” relative to some underlying measure of fundamental value.
It is one of the most well-established investment strategies with an impressive track-record of beating the market.
Countless academic studies have documented this long-term outperformance. Not only that, but legendary investors such as Warren Buffett and Benjamin Graham are living proof of its efficacy.
But with so many different ways to define ‘value’, how should we know which metric to use?
Wouldn’t it be great if there was one metric superior to the rest?
Well, lucky for us, there is.
Having backtested numerous value strategies over long periods of time and in different stock markets, there is one ratio that consistently stands out.
That is the Free Cash Flow Yield.
Not only does this ratio produce extraordinary profits in backtests, but it is also the preferred metric of heavyweight investors such as Terry Smith.
Terry Smith is CIO of the Fundsmith Equity Fund, which has an enviable track-record. I’ve been following him for a long time, and it’s always stuck with me how he values his portfolio with the free cash flow yield.
Free Cash Flow is a ‘Clean’ Measure
It should come as no surprise that free cash flow is the go-to value metric for elite investment professionals.
It is a ‘clean’ measure of a company’s earnings power, as there are no ways to manipulate it with clever accounting tricks like you can with earnings or book value. Even sales can be slightly manipulated through accrual accounting.
Cash at the end of a financial period will always equal cash at the beginning plus or minus any cash made or lost during the period. There is nothing management can do to distort this.
This is where the famous statement “CASH IS KING” comes from.
Free Cash Flow and Free Cash Flow Yield Definition
Free Cash Flow = Cash From Operations + Int(1 – t) – CAPEX
= NOPAT + Depreciation – Change in Net Working Capital – CAPEX
Free Cash Flow Yield = Free Cash Flow/Enterprise Value
Note we are referring to the trailing 12-month free cash flow here.
This article by Yuval Taylor at Portfolio123 gives a great analysis of the different variations of free cash flow and free cash flow yield.
The Theory
You will notice enterprise value (EV) in the denominator of the free cash flow yield instead of market cap (MC).
The reason is simple. The EV version performs better in backtests than the MC version.
As an aside, when we use market cap in the denominator, we are essentially looking at the standard price-to-free-cash flow measure. Price-to-free-cash flow is the reciprocal of the free cash flow yield in this case and is calculated on a per share basis.
Whilst this metric also performs well in backtests, it just isn’t any match for the EV version.
If we look at the definition of enterprise value, this makes sense intuitively.
Enterprise Value = Market Cap + Preferred Shares + Debt – Cash
= Market Cap + Preferred Shares + Net Debt
Unlike market cap, the enterprise value takes account preferred shares, debt, and cash. It tells you what the market is currently valuing the whole business at rather than just the equity portion. This makes it a more complete measure of ‘takeover’ value.
Also, by considering debt and cash, the EV analysis favours companies with healthier balance sheets. If a company has a large amount of cash relative to debt i.e., a healthy net cash position, then this company will be favoured over one that has a small amount of cash relative to debt.
Ok, so now we understand why the free cash flow yield is a great valuation measure.
Now it’s time to back that up with some results…
Backtests Show Extraordinary Profits Overtime
Below are the backtest results from various value strategies across different regional markets. To get a more complete overview of each value metric, read this article about value stock screener critieria.
Due to differing data availability, the historical lookback period varies from market-to-market.
In each case, however, the rebalancing frequency is monthly, and the hypothetical portfolio is constructed of the ‘cheapest’ 10% of stocks based on the respective valuation metric. These stocks are then held in an equal weight. Financials are excluded from the analysis.
That is, at the beginning of each month, the cheapest 10% of stocks from the relevant stock universe are bought in an equal weight; the performance of the equally-weighted portfolio is recorded for that month; and then it is rebalanced at the end of the month.
This process is repeated for the length of the backtest period, producing a time-series of monthly returns for each of the value strategies outlined below.
The results show the cumulative returns of each strategy, the compounded annual return (CAGR), the average annual portfolio turnover, and the implied average holding period for each stock (given the portfolio turnover). All the returns are measured in local currency terms.
Note that these results exclude any transaction costs, so you will have to bear this in mind before implementing these strategies yourself. The portfolio turnover and average holding period should give you an idea of how cost-intensive each strategy would be in real-life.
All of the data comes from Bloomberg.
US
The stock universe for the US backtests was the S&P 500 and the test period was from January 1993 to April 2022.
As you can see, the free cash flow yield (EV) produced the best results over the sample period. Its cumulative return was almost 2 times the second-best performing strategy, which just so happens to be its cousin, FCF yield (MC). It outperformed the S&P 500 by an average of 7% per year, which led to a cumulative return of more than 7 times the S&P 500!
The return charts use a logarithmic scale for ease of comparison.
Source: Bloomberg
UK
The stock universe for the UK backtests was the FTSE 350 (NMX) and the test period was from January 2002 to April 2022.
Again, the free cash flow yield (EV) produced the best results over the sample period with a whopping 15.8% CAGR! It outperformed the FTSE 350 by an impressive 9% per year, leading to a cumulative return of 1876% – more than 7 times the benchmark!
Source: Bloomberg
Europe (ex. UK)
The stock universe for the Europe backtests was the Eurostoxx 600 (SXXP), excluding UK shares. The sample period was from January 2002 to April 2022.
Once again, the FCF yield using enterprise value came way out on top. It had an almost 8% annual outperformance vs. the benchmark, which led to a cumulative return of 1228% – nearly 6 times the return of the Eurostoxx 600.
Source: Bloomberg
Using a Stock Screener to Profit from the Free Cash Flow Yield
Now you’ve seen how profitable a free cash flow yield strategy can be, you’re probably asking how you can incorporate it into your investment process.
There are generally two approaches you can take: a systematic or discretionary approach. In both cases though, you are going to be using a stock screener.
Since the backtests above were based on the 10% of stocks with the highest free cash flow yield, our stock screener criteria should impose the same restrictions. That is, we should get our stock screener to tell us which stocks fall into the top decile based on the free cash flow yield.
Portfolio123 Free Cash Flow Yield Stock Screener
To do this in Portfolio123, type the following formula into the “Rules” tab:
FRank(“(FCFTTM + IntExpTTM * (1 – TaxRate%TTMInd)) / EV”) > 90
Now, while this looks intimidating, all it’s saying is find the stocks that rank in the top decile based on the FCF yield as defined earlier. The “Wizard Rule Builder” makes this process incredibly intuitive.
Here, the stock universe consists of all listed US stocks priced above $3 and with a minimum daily dollar volume of $50,000. However, I could have just as easily chosen the S&P 500 or any of the other 40+ pre-configured universes.
Once you’ve input the formula, simply click “Run Screen”.
Straight away, you’re presented with a list of all the stocks that meet your screening criteria. In this case, the top 10% of stocks with the highest free cash flow yield.
In addition to screening, Portfolio123 can run all sorts of backtests similar to the ones outlined earlier.
For example, here’s the same free cash flow yield strategy with 4-week rebalancing and 0.25% transaction costs, starting in 1999.
And here’s a backtest ranking by decile on the same factor:
GuruFocus Free Cash Flow Yield Screener
Now, not every stock screener provides the same level of flexibility, but there are manual workarounds to achieve the same thing.
For example, if we wanted to find the cheapest 10% of stocks in the S&P 500 (50 stocks) using the GuruFocus stock screener, this is how we would do it:
1) Under the ‘Fundamental’ tab, click on Index Membership and select the S&P 500. This narrows our investment universe down to the same one used in the backtest.
2) Under the ‘Valuation Ratio’ tab, we want to input the correct range next to the EV-to-FCF ratio until we’re left with 50 stocks in the top left corner. Since we’re looking at the inverse of the free cash flow yield here, we want the 50 stocks with the lowest EV-to-FCF, not the highest.
Having said that, we only want to consider stocks with positive EV-to-FCF ratios. Therefore, we need to include a lower bound of 0, which is what we put in the left-hand side box.
Now we just need to input the correct upper bound in the right-hand side box. We do this through a process of trial and error. As you can see in the first image, limiting the range to a maximum of 15 leaves us with 92 stocks, which is too many. Therefore, we need to lower this.
An upper bound of 8 only gives us 27 stocks, which is too low.
The number that gives us 50 stocks exactly is 10.4.
Quant Investing Free Cash Flow Yield Stock Screener
Another stock screener you can use for the free cash flow yield is Quant Investing.
Quant Investing have backtested a whole host of quantitative investment strategies, and give you access to the most profitable ones through their stock screener.
This article shows you the results of their free cash flow yield strategy, and how to implement it in their stock screener. They also incorporate a momentum factor into their test, which improves the results of the standalone free cash flow yield screen.
Note that the backtest results differ to mine due to a different setup. They backtest over a different time frame, use the top quintile (20%) instead of decile (10%), and likely use a different stock universe.
For a closer look at Quant Investing, check out my Quant Investing stock screener review.
Analysing the Stock Screener Output
Ok, so we’ve seen how to implement a free cash flow yield screen with 3 different stock screeners. We now need to do something with the stock screener output. As mentioned earlier, there are two approaches you can take now.
Systematic Approach
The first is a systematic approach. This involves following the exact rules of the backtest in the hope that we replicate its historical success in the future.
Let’s use my earlier backtests as a reference.
Each month, we would buy the 10% of stocks that screen as the cheapest based on the free cash flow yield. No further analysis or cherry-picking of individual stocks takes place. We simply buy all the stocks that come up on our free cash flow yield screen (just like the backtest did).
The benefit of this approach is that we know that we’re getting to a certain degree. By sticking to the backtest rules, we can have confidence that we’re exposed to the underlying factor. We remove individual stock risk, and give ourselves the greatest probability of replicating the strategy’s historical track record.
The downside is that no investment strategy will work 100% of the time, and historical results are not indicative of future results. Factor-based strategies like these go through many years of underperformance. You need to have the discipline to stick with the strategy even when it’s not making any money. Needless to say, this is a very difficult thing to do.
Discretionary Approach
The second approach is a discretionary one. Unlike systematic investing, discretionary investing applies an extra layer of analysis before investing.
For example, instead of buying all of the cheapest 50 stocks from the S&P 500, we might buy 2 or 3 because we like the business from a qualitative standpoint. I would recommend a platform like Koyfin to conduct this research.
The upside of this approach is that it gives you more flexibility. You don’t commit to buying a whole bunch of stocks that you may not want to buy each month. This will not only save you commission charges but might also help you avoid the long periods of underperformance associated with factor-based strategies.
On the flip side, there is no guarantee that you will pick the right stocks. By only selecting a handful of companies, you introduce stock-specific risk. This means that we can’t expect to track the factor-based portfolio, as any one big move from an individual stock will skew the returns. In other words, just because we know the free cash flow yield works as a factor in a diversified portfolio, it doesn’t mean it will have strong predictive power for each individual stock.