Free cash flow (FCF) can best be defined as the cash available from operations minus capital expenditure, and is the cash available to the company to pay dividends, make investments and buy back shares. We defined the free cash flow yield as cash from operations minus capital expenditure, divided by enterprise value. And we analysed the trailing 12-month FCF yield and the 5-year average FCF yield.
If you think about it, a high FCF yield should have strong predictive power over future returns. This may be because the market is less efficient when it comes to pricing free cash flow and its growth in the stock price. Another reason may be because FCF is more difficult to manipulate compared with earnings.
12 Month FCF Yield
As you can see, the 12-month trailing FCF yield is a strong factor and it is very consistent. High FCF companies (Q1) outperform low FCF yield companies (Q5) consistently for all three market size companies, with the outperformance also completely linear over the five quintiles. Thus FCF valuation really matters in separating the winners from the losers. This valuation factor has a strong predictive power for the mid cap stocks, but less so for small companies.
5 Year Average FCF Yield
Even though using the 5-year average FCF yield on mid cap companies (third best single factor we tested) over the test period would have given you a higher return than the 12-month FCF yield, the results for the other market size companies would have been a lot lower. As a factor it is also not strong, with the results not being linear over the five quintiles. Q1 did, however, outperform Q5 by a substantial margin.