Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / How Free Cash Flow Yield Separates Value Traps from Real Buys
Transcript
- Lucas: So the S&P 500 closed yesterday at 7,499, which is basically a stone's throw from 7,500 — a level nobody was talking about six months ago. The Nasdaq is up almost 3 percent in the last five days. And yet, I keep hearing people say 'there are no bargains left.' I think that's lazy. Luna: Lazy or just looking at the wrong numbers? Lucas: Exactly that. If you screen on price to earnings ratio alone, yeah, the median stock in the S&P 500 is trading at about 22 times forward earnings — historically full. But there's a metric that cuts through the noise, and it's one that most retail investors barely use: free cash flow yield. Luna: Let's define that quickly. Free cash flow yield is the company's annual free cash flow divided by its market cap — basically how much cash the business throws off relative to what you'd pay to own the whole thing. Lucas: Right. And it's more honest than earnings per share because it strips out non-cash charges like depreciation and also accounts for the capital expenditures the company actually has to spend to maintain or grow the business. A company can report positive net income but have negative free cash flow — and that's a huge red flag. Luna: So you're saying P/E can be engineered, but cash is harder to fake. Lucas: Exactly. And right now, there are some really interesting divergences. Take JPMorgan Chase. It's trading around 327 dollars, down about 1.8 percent over the last five days. The stock looks expensive on a book value basis — price to tangible book is over 2. But if you look at free cash flow yield, JPMorgan generates enormous amounts of cash. Last year, free cash flow was around 48 billion dollars. Market cap is roughly 400 billion. That's a 12 percent free cash flow yield. Luna: Twelve percent is huge in this market. The ten-year Treasury is yielding maybe 4.3 percent. So you're getting more than double the yield from a bank's cash generation. Lucas: And that's before any buybacks or dividends — JPMorgan's dividend yield is only about 2.2 percent, but the cash flow yield tells you the dividend is incredibly safe and there's plenty of room for increases. Contrast that with Chevron. Chevron's down 3.3 percent in the last five days, trading around 166. On a P/E basis, it's cheap — about 10 times earnings. But free cash flow? In the last twelve months, Chevron's free cash flow was negative. Luna: Negative free cash flow for Chevron? That's surprising given oil prices are still decent. Lucas: It's because capital expenditure has surged. Chevron spent over 18 billion on capex last year, much of it on the Permian Basin and LNG projects. Operating cash flow was around 36 billion, but capex ate more than half of it, and after dividends, free cash flow was about negative 2 billion. So the company is borrowing or selling assets to pay its dividend. Luna: So the dividend yield of around 4.5 percent looks attractive, but it's not backed by free cash flow. That's a classic value trap. Lucas: Exactly my point. A high dividend yield or low P/E doesn't mean the stock is a bargain. You have to look at whether the company can sustain its payout without levering up. Free cash flow yield answers that question directly. Luna: How do you calculate it quickly? I know some listeners might want to run this screen themselves. Lucas: Simplest way: take the trailing twelve months of free cash flow from the cash flow statement. Divide by the current market cap. Multiply by 100. That's your percentage yield. For JPMorgan it's 12 percent. For Chevron it's basically zero or slightly negative. You can find free cash flow numbers on any financial data site — Yahoo Finance, Morningstar, whatever you use. Luna: And what's a good threshold? I've heard some value investors look for at least 8 percent free cash flow yield. Lucas: Eight to ten percent is a solid starting point, but you have to understand the business context. A high free cash flow yield might also signal that the market expects those cash flows to decline — think of a legacy automaker that's about to spend billions on EVs. So you need to pair the metric with a qualitative assessment. But as a first-pass filter, it's far better than P/E. Luna: Are there any sectors where free cash flow yield is systematically distorted? Lucas: Real estate investment trusts and financials, for example. REITs have high depreciation that reduces net income but doesn't affect cash flow. So their free cash flow is often understated if you don't adjust. For banks, free cash flow can be lumpy due to loan loss provisions. But even with those caveats, it's still a more honest measure than earnings for most industrial and consumer companies. Luna: So in a market where the S&P 500 is near all-time highs, you're saying there are still stocks with double-digit free cash flow yields? Lucas: Absolutely. JPMorgan is one. Another example: Alphabet. Market cap around 2.2 trillion, but free cash flow last year was about 70 billion. That's roughly a 3.2 percent free cash flow yield — not spectacular, but solid for a tech giant. And there are smaller names — some regional banks, certain healthcare companies — that are trading at single-digit P/Es but have free cash flow yields above 10 percent. That's where the stock picker's edge is. Luna: It's a reminder that the index isn't the market. Beneath the surface, there are always opportunities if you're willing to do the work. Lucas: And that's really the core of what this show is about. We try to give you frameworks that help you see past the headlines. Luna: You know, speaking of doing the work — a handful of listeners support this show through buy me a coffee dot com slash fexingo, and that's literally what funds us making episodes like this every day. No ads, no sponsors, just listener support. Lucas: Yeah, it's a small group, but it makes a huge difference. If our money conversations have helped you think about a decision differently, that's the whole point. And that's why we keep it ad-free. Luna: Alright. Back to free cash flow yield and how to use it in a concentrated portfolio. Lucas: So once you've identified stocks with high free cash flow yield, the next step is to ask why the yield is high. Is the market undervaluing the cash flows because of a temporary headwind, or is there a structural decline? That's where the concentrated portfolio thesis comes in. Luna: You want to own maybe 15 to 20 stocks where you have high conviction that the free cash flow is sustainable and will grow. Not 100 stocks diversified across everything. Lucas: Exactly. And free cash flow yield is your anchor. If you buy a stock at a 10 percent free cash flow yield and the company grows free cash flow at 5 percent annually, your return over time will approximate 15 percent, assuming the multiple stays constant. That's a powerful compounding engine. Luna: But what if the multiple compresses? Say the market decides free cash flow yield should be 12 percent for that stock — the price would drop. Lucas: That's the risk. But if free cash flow is actually growing, the yield improves over time, and eventually the market recognizes it. The key is to avoid companies where the free cash flow is deteriorating. That's why you need to look at the cash flow statement, not just one number. Luna: So let's bring it back to today's market. The S&P 500 is at 7,500, the Nasdaq is soaring, but we've seen a rotation out of megacap tech into value. Does free cash flow yield favor any particular side of that trade? Lucas: It favors the stocks that are generating real cash regardless of sector. I'd argue that some of the megacap tech names — Apple, Microsoft, Alphabet — have solid free cash flow yields, but they're not screaming bargains. Apple's free cash flow yield is around 3.5 percent. That's fine, but not cheap. Meanwhile, financials like JPMorgan or even some energy stocks that have disciplined capex could be more interesting. Luna: What about Chevron? Would you say it's a value trap based on the negative free cash flow? Lucas: I'd say it's a stock you need to watch carefully. If oil prices stay high and capex moderates, free cash flow could turn positive. But right now, the dividend is not fully covered by free cash flow. That's a risk. I'd rather own Exxon Mobil, which has a stronger balance sheet and more consistent free cash flow generation, even if the yield is lower. Luna: So the takeaway: don't buy a stock just because it's cheap on earnings or has a high dividend. Check the free cash flow yield first. Lucas: Exactly. And if you want to build a concentrated portfolio, use free cash flow yield as your primary screen. Then dig into the reasons behind the number. That's how you separate the real bargains from the value traps.