Investing has a lot of jargon. Not all of it is important. Some of it serves to obfuscate more than elucidate, but some of it can make hard economic decisions much easier to understand.
Many people prefer to invest their money in simple things. It's easy to understand a bond or a CD. You hand someone a check for $1000 and in a year they give you back your $1000 plus 2% interest. You've made $20. Easy!
A bond or a CD is a promise that, as long as whoever issued it stays solvent, you'll earn interest until the maturity date. Any good business has the same goal: to earn money every year. There's no promise that any company will make money in any year—anything can happen—but good companies built to last tend to stay good companies, especially over time.
How is a Stock Like a Bond or a CD?
This difference between stocks and bonds makes buying a bond easier than buying a stock, because you know what to expect. What may surprise you is that you can analyze bond and stock returns the same way. (This is an insight explained in the book Buffettology, by Mary Buffett.) The market may go up, down, or sideways, but if you're careful about what you buy and why, you can have reasonable expectations and buy only good companies with great prospects.
While stock returns often come in the form of increased price (buy low, sell high!), you can make money on dividends and you can project how much the price of a stock will increase over time by how much money the business produces.
How Much Can a Stock Return?
"Wait a minute," you might say. "If a stock has no guaranteed return, how can you determine what that return might be?"
The answer starts, as usual, with earnings. At the end of the company's year, how much cash did it bring in? Not how much cash is on the accounting sheet (it's too easy to manipulate that), but how much cash is available in the company's accounts. How many dollar bills could they stack in the lobby? Free cash flow is the measurement of actual money the company has realized.
A company that has positive free cash flow made money. A company that has negative free cash flow lost money. Everyone wants to make money. Otherwise, you'll have to keep pouring money into the business just to stay in business, and you'll eventually run out of money and potential investors. (Enron hid its escapades by manipulating cash flow reporting.) Sure, their accounting sheets showed amazing profits, but you have to pay the electric company with real dollars or they'll turn off your lights.)
Cash Yield and Free Cash Flow Yield
Free cash flow is only part of the story. What did you pay for the stock? Remember the bond: for every $1000 you put into the bond, you earn 2% interest in a year, or $20. In other words, it costs you $1000 to make $20 in a year.
What if you treated a stock's free cash flow like the earnings on a bond? In other words, what if you could divide the free cash of the business by the entire amount of money invested in it? That'd give you an idea of what people are willing to pay to for a business that generates that cash. Cash yield is the ratio of free cash flow to the business's market capitalization. Free cash flow yield is another way to describe this.
Cash on Cash Yield is slightly different, and it's used more to describe real estate or other incoming-producing investments. Instead of using market capitalization, it uses the price you paid for an investment as the denominator. For example, if you paid $100,000 for a rental property that earned you $1000 a month, you'd have a cash on cash yield of $12,000 (12 times $1000) divided by $100,000 or 12% annually. This calculation is important when evaluating an investment which produces income; it's a little less important for stocks, where the current market capitalization and free cash flow represent the market's opinion of the business's ability to generate cash. In other words, because the stock price isn't fixed in the same way a rental property's price might be, you have to use a different valuation mechanism.
How to Calculate Cash Yield
To calculate the free cash flow yield of a stock, you need to know how much it would cost you to buy the entire company right now. This is market capitalization: the current price of the stock (what you can buy it for right now) multiplied by the total number of stocks available.
If the company has 10 shares available at $1000 apiece, the market capitalization is $10,000. If the company has $200 in free cash flow last year, the cash yield is $200 divided by $10,000, or $20 per $1000 share. That's 2%, the same as the bond.
Here's the fun part. What if the price of the stock goes down to $800? The cash yield of the stock jumps to 2.5%. Even if the company makes the same amount of money next year, each share of stock is worth more because it represents a larger amount of real dollar earnings. (This is different from when the company performs stock buybacks, because that changes the denominator of this ratio.)
What is a Good Free Cash Flow Yield?
This ratio is a tool; it can't tell you the future of a business. It's a simple piece of information you can use as part of your analysis. What's a good cash yield? It depends; how fast can the business grow? What's the limit on its growth? A Facebook can't double its userbase more than a couple of times without running out of humans, while a smaller company like Electro Scientific Industries has a lot more room to expand.
In general, the higher the free cash flow yield the better. 8% for a mature company such as Coca-Cola would be fantastic. A smaller, newer business could see 20% a year as fantastic. Keep this number in context.
How to Use Cash Yield
The free cash flow yield ratio is a good metric because it relies on two figures which are difficult for shady businesses to manipulate. You can hide a lot of things in raw earnings, but cash flow is what it is. So is market capitalization.
Once you calculated the free cash yield of a stock, you can compare investing $1000 in the company to buying a bond at $1000. Is the bond safer? Is the company likely to make more money next year? Which is the best investment for you?
As a buy-and-hold investor—someone willing to buy stocks based on their value—the cash yield is an important figure. It helps us decide a fair price for good stocks, and helps us understand companies that aren't really making money. It also provides a baseline for investment safety: a stock that can't beat the return of a government bond isn't worth your time.
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