Adjusted cash flow yield

What Is Adjusted Cash Flow Yield?

Adjusted Cash Flow Yield is a financial metric used in fundamental analysis to assess a company's ability to generate cash relative to its overall value, particularly after accounting for its outstanding financial obligations. More specifically, it is often referred to as Liability Adjusted Cash Flow Yield (LACFY). This metric refines traditional cash flow measures by incorporating a broader view of a company's financial structure, including its liabilities. It aims to provide investors with a more comprehensive understanding of the actual cash available to the owners of the company after considering what is owed.

History and Origin

The concept of valuing companies based on their cash generation has roots in discounted cash flow methodologies, which have been employed in various forms since ancient times, notably gaining prominence after the 1929 stock market crash. However, the formal requirement for public companies in the United States to include a statement of cash flows as part of their financial statements only became standard in 1988 with FASB Statement No. 95.²⁰ The push for standardized financial reporting, including clear cash flow information, intensified with the creation of the U.S. Securities and Exchange Commission (SEC) following the Great Depression.¹⁸, ¹⁹

The specific metric of Liability Adjusted Cash Flow Yield (LACFY) was conceived by stock market commentator John DeFeo, drawing inspiration from the principles of value investing pioneers Benjamin Graham and David Dodd. This development emerged from a desire to create a valuation formula that better reflected the "true ownership yield" of a company in light of modern accounting standards, moving beyond metrics solely focused on reported earnings.¹⁷ The SEC continues to emphasize the importance of accurate and high-quality cash flow information for investors to fully understand a company's financial condition.¹⁶

Key Takeaways

• Adjusted Cash Flow Yield (often referred to as Liability Adjusted Cash Flow Yield or LACFY) provides a valuation metric that considers a company's cash flow relative to its total enterprise value, including its debt.
• It aims to offer a more complete picture of a company's financial health and its ability to generate sustainable cash for its owners.
• The metric can be particularly useful for comparing companies with differing capital structures, as it accounts for both equity and debt obligations.
• A higher Adjusted Cash Flow Yield generally suggests that a company is generating robust cash flow relative to its adjusted value, potentially indicating an attractive investment.
• While insightful, the Adjusted Cash Flow Yield has limitations, especially for fast-growing companies or those with complex accounting practices.

Formula and Calculation

The Liability Adjusted Cash Flow Yield (LACFY) is calculated by comparing a company's long-term free cash flow to its adjusted total value, which incorporates both equity and debt.

The formula for Liability Adjusted Cash Flow Yield (LACFY) is:

Where:

• 10-Year Average Free Cash Flow: Represents the average cash generated by the company over the past decade, after accounting for necessary business expenses and capital expenditures. This provides a smoothed view of long-term cash generation.
• Outstanding Shares: The total number of a company's shares currently held by investors.
• Options + Warrants: Potential shares that could be created if stock options or warrants are exercised, increasing the total shares outstanding.
• Per Share Price: The current market price of one share of the company's stock. Multiplying this by the sum of outstanding shares, options, and warrants provides a more comprehensive view of the company's market capitalization.
• Liabilities: All financial obligations of the company, both short-term and long-term.
• Current Assets - Inventory: This component effectively represents quick assets available to offset some of the liabilities. Inventory is typically excluded because it is less liquid and may not be readily converted to cash. This also relates to how working capital is assessed in some contexts.

The denominator in the formula approximates a form of enterprise value, which measures a company's total value, encompassing both its equity and debt, and is often considered the theoretical cost of acquiring the entire company.¹⁴, ¹⁵

Interpreting the Adjusted Cash Flow Yield

Interpreting the Adjusted Cash Flow Yield (LACFY) involves evaluating the resulting percentage as an indicator of a company's ability to generate cash relative to its comprehensive value. A higher LACFY suggests that a company is producing a substantial amount of free cash flow relative to the total capital invested in it, including debt. This can signal strong financial health and potentially an undervalued investment, as it implies a robust cash return on the overall cost of acquiring the business.¹³

Analysts often compare a company's LACFY to a benchmark, such as the yield on a 10-year Treasury note. A larger difference between the LACFY and the Treasury yield generally suggests a more attractive investment, indicating a higher potential return relative to a risk-free rate. Conversely, a small difference or a lower LACFY might imply that the company is overvalued or has less appealing cash-generating power relative to its overall financial obligations. This metric offers a nuanced perspective for valuation by integrating the impact of liabilities, which is crucial for understanding the true financial flexibility of a firm.

Hypothetical Example

Consider "Alpha Corp.," a manufacturing company, and "Beta Tech," a software firm.

Alpha Corp. Data:

• 10-Year Average Free Cash Flow: $50 million
• Outstanding Shares: 100 million
• Options + Warrants (converted to shares): 5 million
• Per Share Price: $10
• Liabilities: $400 million
• Current Assets: $150 million
• Inventory: $50 million

Calculation for Alpha Corp.:

Denominator Calculation:
((\text{100 million} + \text{5 million}) \times $10 + $400 \text{ million} - ($150 \text{ million} - $50 \text{ million}))
((105 \text{ million} \times $10) + $400 \text{ million} - $100 \text{ million})
($1,050 \text{ million} + $400 \text{ million} - $100 \text{ million})
($1,350 \text{ million})

Adjusted Cash Flow Yield for Alpha Corp.:
(\frac{$50 \text{ million}}{$1,350 \text{ million}} \approx 0.037 \text{ or } 3.7%)

Beta Tech Data:

• 10-Year Average Free Cash Flow: $30 million
• Outstanding Shares: 50 million
• Options + Warrants (converted to shares): 2 million
• Per Share Price: $25
• Liabilities: $100 million
• Current Assets: $80 million
• Inventory: $10 million

Calculation for Beta Tech:

Denominator Calculation:
((\text{50 million} + \text{2 million}) \times $25 + $100 \text{ million} - ($80 \text{ million} - $10 \text{ million}))
((52 \text{ million} \times $25) + $100 \text{ million} - $70 \text{ million})
($1,300 \text{ million} + $100 \text{ million} - $70 \text{ million})
($1,330 \text{ million})

Adjusted Cash Flow Yield for Beta Tech:
(\frac{$30 \text{ million}}{$1,330 \text{ million}} \approx 0.022 \text{ or } 2.2%)

In this hypothetical example, Alpha Corp. shows a higher Adjusted Cash Flow Yield (3.7%) compared to Beta Tech (2.2%). This suggests that Alpha Corp., despite potentially having a larger total value including debt, generates more cash flow relative to that comprehensive value available to its equity and debt holders.

Practical Applications

Adjusted Cash Flow Yield (LACFY) serves as a valuable metric in several practical financial applications, particularly for investors and analysts focused on a company's underlying cash-generating capability.

• Company Valuation: LACFY provides an alternative perspective for company valuation, especially when considering a potential buyout or acquisition. It helps determine how long it might take for an acquisition to become profitable based on the target company's cash generation relative to the total cost, including assumed liabilities.
• Investment Screening: For value investors, a high Adjusted Cash Flow Yield can signal that a company is undervalued relative to its ability to generate cash flow. This offers a robust way to identify potentially attractive investment opportunities.
• Comparative Analysis: LACFY enables a more accurate comparison of companies with diverse capital structures. Unlike metrics that only consider equity market capitalization, the Adjusted Cash Flow Yield accounts for both debt and cash, providing a more normalized view of a company's total value. This is especially relevant when assessing potential acquisition targets, as the enterprise value of a company, which forms the basis of the denominator, offers a comprehensive measure of its total value.¹¹, ¹²
• Dividend Sustainability: Investors seeking income from dividends can use LACFY to gauge the sustainability of a company's payouts. A strong Adjusted Cash Flow Yield indicates that the company generates sufficient cash to cover its operational needs, invest in growth, and comfortably support dividend payments.¹⁰ John DeFeo, the creator of LACFY, even proposed a "Dividend Acid Test," suggesting that a dividend yield greater than LACFY could signal a forthcoming dividend cut.⁹
• Financial Health Assessment: This metric offers insights into a company's ability to cover its financial obligations beyond just operating expenses. By factoring in liabilities, it highlights whether a company generates enough cash to service its debt and still have a surplus. The U.S. Securities and Exchange Commission (SEC) consistently emphasizes the critical role of cash flow information in providing investors with a complete picture of an issuer's financial health.⁸

Limitations and Criticisms

While Adjusted Cash Flow Yield (LACFY) offers a more comprehensive view of a company's financial health than simpler metrics, it is not without its limitations and criticisms.

One notable drawback is its potential unsuitability for all company types. For instance, it may not provide a fair valuation for fledgling companies or those experiencing dramatic earnings growth, as their cash flow patterns might be irregular due to heavy reinvestment in growth initiatives.⁷ Similarly, companies with significant overseas cash hoards or artificially low tax rates could appear to have a higher Adjusted Cash Flow Yield than their true underlying financial strength might suggest, due to accounting nuances that the formula may not fully capture.⁶

Furthermore, like other cash flow-based metrics, LACFY can be sensitive to management's decisions regarding capital expenditures or the timing of payments, which could temporarily boost or depress the reported free cash flow. Investors should analyze the sustainability and consistency of cash flow generation over time rather than relying on a single period's figure.⁵

Critics of cash flow valuation models, such as the Discounted Cash Flow (DCF) approach which informs the basis of free cash flow, point out that projecting future cash flows and determining an "appropriate discount rate" can be inherently challenging and rely on significant assumptions. This uncertainty in forecasting can lead to wide variations in valuation outcomes.⁴ The effectiveness of Adjusted Cash Flow Yield can also vary significantly across different industries due to their distinct business models and capital requirements, making cross-industry comparisons less reliable.³

Adjusted Cash Flow Yield vs. Free Cash Flow Yield

While both Adjusted Cash Flow Yield (LACFY) and Free Cash Flow Yield are valuable valuation metrics, the key distinction lies in how they account for a company's capital structure and obligations.

Free Cash Flow Yield (FCFY) is typically calculated by dividing a company's free cash flow by its market capitalization or, in some cases, its enterprise value. It measures the cash generated that is available to all providers of capital (debt and equity) or, when using market capitalization, specifically to equity holders, relative to the company's market value. A high FCFY generally indicates that a company generates substantial cash relative to its stock price, making it potentially attractive to investors.¹, ²

Adjusted Cash Flow Yield (LACFY), on the other hand, is a more refined metric that explicitly "adjusts" for a broader scope of a company's financial obligations and assets in its denominator. As defined by its originator, it compares long-term average free cash flow to a comprehensive value that subtracts liquid assets (current assets minus inventory) from the sum of market capitalization and all liabilities (including options and warrants). This adjustment provides a deeper understanding of the "true ownership yield" by taking into account the company's full financial position beyond just its market-traded equity. Essentially, LACFY is considered to offer a more complete picture of a firm's finances by incorporating the impact of its liabilities.

FAQs

What is the primary purpose of Adjusted Cash Flow Yield?

The primary purpose of Adjusted Cash Flow Yield (LACFY) is to provide a more comprehensive valuation metric that accounts for a company's cash flow relative to its total value, including all outstanding financial obligations. It aims to show the true cash generation capacity available to the owners after considering debt and liquid assets.

How does it differ from traditional earnings metrics?

Unlike traditional earnings yield or price-to-earnings (P/E) ratios, which are based on net income from the income statement, Adjusted Cash Flow Yield focuses on actual cash generated. Cash flow is often considered a more reliable indicator of a company's financial health because it is less susceptible to accounting manipulations and non-cash expenses like depreciation.

Can Adjusted Cash Flow Yield be negative?

Yes, Adjusted Cash Flow Yield can be negative if a company's free cash flow is negative, meaning it is not generating enough cash to cover its operational expenses and capital expenditures. A consistently negative yield can signal financial distress or significant investment phases.

What financial statements are needed to calculate Adjusted Cash Flow Yield?

To calculate Adjusted Cash Flow Yield, you primarily need information from the company's cash flow statement to determine free cash flow, and its balance sheet and market data to ascertain outstanding shares, share price, liabilities, current assets, and inventory.