Given the importance of both free cash flow and valuation, investors may want to consider adding liability-adjusted cash flow yield (LACFY) to their repertoire of analysis tools. LACFY offers investors an ability to quickly gauge the value of a company's stock relative to its free cash flow history and make relative valuation calls within an industry or sector, as well as a quick acid test of a company's dividend policy. Though LACFY is not perfect and does not work in all situations, it holds up well as a fast and easy evaluation metric. (For more, check out Free Cash Flow Yield: The Best Fundamental Indicator.)
Defining LACFY
The calculation of LACFY is straightforward. Take the historical average of a company's free cash flow (that is operating cash flow minus capital expenditures) and divide that number by the sum of market capitalization, liabilities and current assets net of inventory. LACFY is basically a measure of the "cash on cash" returns that an investor could expect if he or she owned the entire company outright.
In other words:
| LACFY = 10-year average free cash flow ÷ (market capitalization + total liabilities – (current assets – inventory) |
This equation is simple, but it elegantly handles a few of the thornier aspects of cash flow-based methodologies. By using a multi-year average, LACFY largely neutralizes the year-to-year volatility that can come from working capital adjustments (running down inventory, for instance) or changes in cap-ex and can capture what should be a full economic cycle for a company.
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