Are you are a growth investor or a value investor? The investment profession does its darnedest to fit fund managers into one camp or the other, and many investors do likewise when determining whether a company is a growth or value play. However, as Warren Buffett counsels, growth and value are joined at the hip. To invest successfully, a Fool must understand both concepts.
In the May issue of Smart Money magazine, James Stewart tries to define the two types of investing: Value investors look for stocks with undervalued pasts, while growth investors seek stocks with undervalued futures. But both aspects are important to consider when calculating free cash flow yield.
The benefits of free cash flow yield
Free cash flow yield is simply the inverse of the price-to-free cash flow ratio (P/FCF). When stated as a percentage, it offers useful insight into how much free cash flow a stock is yielding. A Foolish investor could compare a stock's free cash flow yield to the yield on the 10-year Treasury, for example, to see whether the stock offers sufficient compensation for its additional risk.
Free cash flow yield is a useful tool to gauge companies in more mature industries, such as Anheuser-Busch (NYSE: BUD ) or Coca-Cola (NYSE: KO ) . With their hefty market shares, and slow demographic growth in their primary markets, neither company will experience blazing future growth. Their industries have become grudge matches, as they battle their leading competitors -- Miller for Anheuser-Busch, and PepsiCo (NYSE: PEP ) for Coke -- for a larger portion of an existing pie. Free cash flow and its yield are easier to calculate with companies like these, which enjoy a reasonably steady rate of growth.
But what about a smaller, faster-growing company operating in a more dynamic industry? In these cases, the market pie may be growing, and a fast-moving firm, like Apollo Group (Nasdaq: APOL ) in education or PetSmart (Nasdaq: PETM ) in pet-supply retail, has a chance to grab a hefty piece of it. Free cash flow yield may not be the best way to judge the performance of companies like these, since they're likely plowing capital back into the business to fuel expansion.
There are two handy ways to better evaluate free cash flow for a growing company. The first one involves breaking down a company's capital expenditures, separating the money spent to grow the business from the funds used to maintain it. Whitney Tilson wrote eloquently about maintenance versus growth capex in an earlier Fool article.
The second, lesser-known technique is called free cash flow total return. I first heard the term in a recent interview with Bill Miller, the market-thumping head of Legg Mason's Value Trust, where he defined it as "free cash flow yield, plus the anticipated growth in free cash flow yield."
Putting it into practice
Here's how it works. In my article last week on Bed Bath & Beyond (Nasdaq: BBBY ) , I noted that the company's free cash flow yield was roughly 3.7%. On its own, that's not exactly the sign of a compelling investment. However, when you consider the company's projected free cash flow growth, things get more interesting. For reasons I referenced in my article, it's reasonable to expect Bed Bath & Beyond to increase cash flow 10%-12% over the next five to 10 years. That puts the free cash flow total return in the 13%-16% ballpark.
Another example: In recent interviews, Bill Miller estimated that Dell (Nasdaq: DELL ) has a free cash flow total return of roughly 19%-20%. That's calculated as a free cash flow yield of around 7%, plus projected free cash flow growth of 12%-15%. Now we're talking!
Clearly, it's a lot simpler to calculate free cash flow yield than free cash flow growth. The latter requires estimates of firm growth, profitability, industry dynamics, competitors' ability to narrow an economic moat over time -- the sort of things you usually need a crystal ball for. Free cash flow total return handily provides a useful framework for making these necessary decisions when you're sizing up a stock. It also makes it a bit easier to find compelling companies trading at a sufficient margin of safety.
Fool contributor Ryan Fuhrmann is long shares of BBBY and PETM. Feel free to email him with feedback or your own thoughts on free cash flow total return. The Fool's disclosure policy yields to no one.