Free cash flow yield
Earnings are an opinion; cash is a fact. What the business actually hands its owners, as a yield on what they pay.
- Build levered free cash flow from EBITDA
- Calculate the equity and unlevered free cash flow yields
- Find the market cap and multiple that a target yield implies
- Show what a buyback at that yield does per share
The intuition
If you buy a flat to rent out, the question is not what the accounts say it earned but how much cash lands in your account each year after the mortgage, repairs and tax, compared with what you paid. $9,000 a year on a $100,000 flat is a 9% yield, which you can set against what a savings account pays.
Free cash flow yield asks the same of a stock: the cash left after the capex the business needs, interest, tax and working capital, divided by the market cap. The unlevered version is measured before interest and divided by enterprise value, so it compares businesses whatever their debt.
Cash taxes = tax rate × (EBITDA − D&A − interest). Levered FCF = EBITDA − capex − interest − cash taxes − increase in working capital. FCF yield = levered FCF ÷ market cap. Unlevered FCF = levered FCF + interest × (1 − tax); unlevered yield = unlevered FCF ÷ EV.
Why it works
- The conventions here: cash tax is charged on EBIT after interest, so D&A matters only through the tax it saves. Market cap = EV − net debt. An increase in working capital absorbs cash; a decrease releases it.
- Depreciation reduces tax but not cash, so more D&A, everything else equal, means more free cash flow.
- Set the yield against a bond yield. A 9% FCF yield in a stable business is a 9% coupon that can grow; a yield below the bond yield means the price is paying for growth.
- Adding back after-tax interest removes the capital structure: the same business with different debt has the same unlevered FCF and yield.
- A buyback at today's price retires FCF ÷ market cap of the shares in a year, so FCF per share rises by 1 ÷ (1 − that share) − 1.
- Normalize before you capitalize. A capex holiday or a one-off working-capital release can flatter one year's FCF; divide a normal year's cash, not a lucky one.
| Interest: 200 × 6% | $12M |
| Cash taxes: 25% × (100 − 20 − 12) | $17M |
| Levered FCF: 100 − 20 − 12 − 17 − 5 | $46M |
| Market cap: 1,000 − 200 | $800M |
| FCF yield: 46 ÷ 800 | 5.75% |
| Unlevered yield: (46 + 12 × 75%) ÷ 1,000 | 5.50% |
For an 8% yield the market cap would be 46 ÷ 8% = $575M, or 7.75x EBITDA once net debt is added back: 28% below today.
The formulas
Tax on earnings after interest.
Cash left for shareholders.
The cash return on the price of the equity.
Cash before financing.
Comparable across capital structures.
Run it backwards.
Worked example
Interest first, then cash taxes, then take everything off EBITDA. Divide by the market cap, which is EV less net debt.
See it move
Same company and the same EBITDA. Change capex, D&A, leverage, working capital, the EV/EBITDA multiple and the yield you think the equity deserves.
- Raise capex. Free cash flow and the yield both fall.
- Raise D&A. Cash taxes fall, so free cash flow rises.
- Raise net debt. Levered FCF falls, but the unlevered yield does not move: it is measured before financing.
- Raise EV/EBITDA. Free cash flow does not change and the yield falls; the multiple the target implies stays put.
- Raise the target yield. The multiple it implies falls, and so does the upside.
Run it backwards
Same company, reversed: you think the equity should trade on a set free cash flow yield. What market cap and multiple is that?
Free cash flow divided by the target yield is the market cap that gives that yield. Add net debt for enterprise value, divide by EBITDA for the multiple, and compare with today's market cap.
The yield you choose is a judgment about growth and risk, and the cash flow is one year of a lumpy number, so normalize it before dividing.
Traps
Say it in the interview
“Why would a hedge fund analyst look at free cash flow yield rather than P/E?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Levered FCF = EBITDA − capex − interest − tax − ΔNWC.
- FCF yield = levered FCF ÷ market cap.
- Unlevered: add back interest × (1 − tax), divide by EV.
- Market cap for a target yield = FCF ÷ target yield.