One of the big reasons for revamping our screening tools was to be able to provide a Magic Formula®-like ranking using free cash flow yield instead of earnings yield.

Most value investors will tell you that free cash flow is the purest measure of a company's success. The purpose of a business is to use assets to generate cash, cash which can be used to reward owners in the form of reinvestment (to generate even more cash!), or paid out in the form of dividends or share buybacks. What better way to measure the cost of a business then comparing the price to the cash the company is generating!

Earnings yield, the traditional Magic Formula® metric for valuation, uses reported earnings, with some adjustments to eliminate non-operating factors like tax rate, interest costs, and "one-time" items like restructuring and asset write-downs.

After looking carefully at the differences between the two techniques, I see advantages - and disadvantages - to both. Let's take a look at the top 25 stocks over $1 billion market cap using each metric and discuss some about the differences of each metric to rank our Magic stocks.

The Top 25 Using Each Metric

Here are the top 25 over $1 billion, ranking by earnings yield (using our screener tool):

And here is the same list, but using free cash flow yield in place of earnings yield. For free cash flow, we use the traditional calculation of (Operating Cash Flow - CapEx). However, if depreciation costs are lower than capital expenditures, we use that instead. The reason for this is that, for growth companies in particular, a large portion of "cap ex" is actually reinvestment for growth. A longer explanation can be found here.

Comparing The Two Metrics

So first of all, there is over 50% overlap between the two screens (13 stocks out of 25 are the same). This makes a lot of sense, as cash flow should roughly approximate reported earnings.

Looking over the different stocks, there are a few reasons why certain stocks show up (or don't show up) in the free cash flow screen:

• Minority Interest Effects: Several stocks have significant minority ownership, meaning not all of their earnings (or cash flow) belong to shareholders. Income statements include this value, allowing us to subtract it for the purposes of earnings yield. On the other hand, free cash flow statements don't generally allocate cash to minority interests. This skews the free cash flow yield higher and causes some stocks to be ranked. Examples of this include PINC, LTRPA, SCAI, and AMSG.
• "Lump Sum" Businesses: A number of business models involve large cash payments that are amortized over the life of a contract. This can work both ways. If the trailing twelve months contains one of these large payments, the stock is more likely to be screened by free cash flow. On the other hand, if the last large payment fell out of the trailing twelve months, it would be more likely to be screened using earnings yield. Several industries fall into this model: engineering and construction, development-stage pharmaceuticals, and licensing businesses are three notable ones. CBI is one example, with payments being delayed on their nuclear contracts signed years ago. DEPO is another - it booked nearly $150 million in "future royalties" revenue a quarter ago, but the cash for that will come in over the next several years.
• Business Models With Low Working Capital Requirements: The final reason is simply that some stocks with higher earnings yields don't have business models that generate as good a cash flow conversion as others. Consider a company like GME (not in cash flow screen) vs. MSFT (not in earnings yield screen). GME has to spend cash to re-stock its stores with inventory every day, while MSFT's businesses are (predominantly) inventory-free. This allows MSFT to generate a free cash flow yield very close to its earnings yield (8.3% vs. 8.8%, respectively). On the other hand, GME's working capital requirements force a much lower free cash flow yield (7.0% vs. 13.9%). Tax and interest payments on debt are other primary reasons for discrepancies in earnings vs. cash flow.

Which Is Better?

A straightforward answer to the question, in my opinion, is that the earnings yield screen is better in most cases. It accounts for minority interest effects, and "smooths out" lump sum businesses for a better idea of ongoing earnings power. If I could only screen using one of the two, earnings yield would be it.

That said, having free cash flow yield available is extremely useful. One thing I've been doing is punching in interesting stocks to the single stock calculator and comparing their earnings and free cash flow yield. A FCF yield approximating earnings yield is a quick verification that this is, indeed, a business selling cheaply against its earnings power. However, if the two metrics are widely divergent, perhaps the business isn't as attractive as it initially appeared.