By examining a company’s sales, earnings, and cash flow, valuation measures provide investors with an easy way to determine its worth.
To decide if an investment is appealing, these measurements compare the firm’s value to the market’s evaluation of the company.
Let’s look at the most popular valuation methods and see why we think free cash flow yield is the most valued of them all.
Investors can utilize a variety of value metrics. So, which is the better option? Let’s take a look at a few of the most prevalent ones.
A lower ratio, with the exception of free cash flow yield, implies a more appealing investment.
What do each of these measures mean, and what do they tell investors, putting aside the definitions? Is it true that all measurements are created equal?
As Buffett points out, the most essential indicator is free cash flow, and other metrics are only a guide to determining free cash flow.
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.” – Warren Buffett’s 2000 Annual Letter
Since December 31, 1991, a portfolio based on each of these indicators has done well, as seen in the chart below. The investor had the largest return and the fewest times of negative return when using free cash flow yield (free cash flow/enterprise value).
There’s no way of knowing whether free cash flow yield will continue to give the best returns in the future. In fact, there have been times in the past when companies with high free cash flow yields underperformed. Nonetheless, we feel there is a compelling reason to use free cash flow yield to invest.