Free cash flow yield is a method of stock evaluation that measures how much cash flow a company is producing compared to its market price. Calculation of this ratio is done by dividing the amount of a free cash flow a company has per share by the company's current market price per share. A high free cash flow yield usually represents a good investment opportunity, since investors would be paying a small price and getting high earnings in return. This type of ratio is a useful measuring stick for investors because it provides an accurate representation of possible returns for mature companies as opposed to somewhat deceptive ratios based on earnings alone.
Investors often look first at a company's earnings when they judge investment opportunities. This can be misleading, because discerning a company's true financial strength through earnings reports is difficult due to inconsistent accounting practices. On the other hand, it's difficult to modify cash flow. A company with a strong cash flow has the ability to build its business through new products, advanced marketing initiatives, paying off debt, and the like, and is therefore attractive to investors.
To arrive at the free cash flow yield, the amount of free cash flow must first be calculated. This is done by adding all of a company's net income plus any amortization, and then subtracting capital expenditures and any changes in working capital. The amount left over represents the amount of working cash flow a company has at hand.
By comparing this to the market price, investors then get a strong picture of the overall economic strength of a business. Free cash flow yield is an effective measuring stick for mature businesses that are unlikely to experience any explosive growth. If the amount of cash flow one of these companies has consistently at hand is out of proportion with its market price, then investors may have an opportunity for a good return.
One caveat with free cash flow yield calculations is that it might not be the best way to judge younger, growing businesses. Businesses like these have the tendency to sink a lot of cash on hand into investments to grow the business into a stable, long-lasting entity. At these early points a business' existence, the free cash flow yield can be low or even negative for companies of this type. In cases such as this, the free cash flow yield number may fall short as an accurate indicator of the financial potential of the company.