- Cash flow is a key metric for measuring financial performance, helping eliminate confusion from non-cash expenses.
- Free cash flow yield shows how much cash a firm generates versus its market value.
- Stocks with high free cash flow yields can reinvest into their business to create more value.
The ultimate goal of a business is to generate cash for its shareholders. Investors often consider net income the “bottom line” of a business, indicating how much profit it makes. Net income equals revenue minus expenses. However, some types of revenue and some types of expenses don’t result in the receipt or payment of cash. This includes things like depreciation, amortization, accruals, and deferrals.
When using cash flow as the indicator of business profitability, all these items get stripped out. This creates a clearer picture of how much money a company makes in a period that it can reinvest or return to shareholders. Free cash flow is a good metric to use.
Taking this a step further, adjusting the amount of cash flow a business generates compared to its market value can be useful. Investors can use a stock’s free cash flow yield to do this. This metric divides free cash flow by market capitalization. Free cash flow yield indicates the firm’s ability to reinvest that cash or pay it out as dividends relative to its size.
The relative nature of this measurement is important. Investing $1 million in a $10 million business can yield more growth than investing the same amount in a $10 billion business. Below are three companies that are generating huge amounts of free cash flow for their size.
Reinsurance Group of America: Reinsurance Stock With Cash Flow Over Half Its Market Value
Reinsurance Group of America (NYSE:RGA) boasts a free cash flow yield of 60%. This means that over the last twelve months, the amount of free cash flow it racked in was equal to 60% of its market capitalization. The financial services company specializes in providing life and health reinsurance. Reinsurance is the business of providing insurance to insurance companies.
Let’s say there is a natural disaster that kills thousands of people in an area where one insurance company has a lot of life insurance policies. In that case, that insurance company is going to have to pay out millions or billions of dollars worth of claims at once. This could conceivably bankrupt the insurance company. However, through a reinsurance agreement, that insurance company can offload the responsibility to pay some of those claims to a reinsurer.
Because the reinsurer has capital to pay claims, the number of people who can access insurance expands. The company's gross profit has been very high for five quarters, showing that its premiums exceed the claims it pays. This is contributing to the firm’s large cash flow.
Capital One Financial: Credit Card Company With Billions in Cash Flow
Capital One Financial (NYSE:COF) has a free cash flow yield of 31%. It is primarily a credit card company. Credit card companies have a huge free cash flow because a large portion of their expenses are non-cash.
In the first nine months of 2024, Capital One’s net income was $3.6 billion. However, after adding in $9.1 billion from “provision for credit losses” and other items, the company’s free cash flow is nearly $15 billion. The “provision for credit losses” line item calculates how much of the company’s loans it should expect to not have repaid, based on historical data. Capital One doesn’t want to overextend itself by investing a massive amount of this into long-term projects, in case the loans actually default. However, it still serves as a source of cash that the company can access and invest in low-risk initiatives.
Plains GP Holdings: Midstream Infrastructure Stock With Big Non-Cash Expenses
Plains GP Holdings (NASDAQ:PAGP) has generated a 49% free cash flow yield over the past twelve months. The company has a massive amount of expenses in the form of depreciation and amortization. Along with other items, these non-cash adjustments take the company’s net income of -$206 million to a free cash flow of $2.1 billion. This makes sense. Plains GP's business is to acquire stakes in midstream oil and gas infrastructure. This includes pipelines, storage, and processing systems.
When this happens, the company adds an asset with a finite life to its balance sheet. Over time, the firm must depreciate the value of that asset until it is worth $0 on paper. Since depreciation is a non-cash expense, it reduces the company’s net income but not its free cash flow. Thus, Plains GP maintains the capability of investing a significant amount of cash despite its negative net income.