Why Goldman Is Warning About Free Cash Flow Yield (GS)

The Goldman Sachs Group Inc. (NYSE: GS) is alerting investors to the importance of cash flow metrics in equity valuation and recommending stock analysis using one particular alternative cash flow metric.

In a June 2016 research report titled "The Cash Flow Mirage," Goldman Sachs offered observations in regard to inventory levels and cash flow, and suggested utilizing the metric of debt-adjusted cash flow (DACF) over free cash flow (FCF) in order to more accurately identify value stocks. Goldman Sachs believes that many equity stocks are extremely overvalued when analyzed with common financial ratios such as the price/earnings ratio (P/E), while analysis based on cash flow metrics reveals stocks that may offer investors value.

Declining Inventories and Capital Expenditures

However, Goldman Sachs cautions that cash flow figures may be deceptive due to low levels of capital expenditures (CAPEX) and drawdowns in inventory levels. Inventory drawdown provides a temporary boost to cash flow. Allowing inventory levels to decline and not making major investments in business expansion typically signals that the company does not believe substantial growth opportunities exist in the immediate future.

Goldman Sachs' report noted that, while there was considerable build-up in inventories between 2010 and 2014, inventories were largely flat for 2015. The aggregate inventory total for sectors Goldman Sachs identifies as inventory-sensitive showed less than 1% average growth in 2015, as compared to 6% average growth for 2011-14. The report also mentioned that sales growth was near zero for 2015. Despite inventory reductions in 11 out of 25 sectors examined by Goldman Sachs, overall inventories are still at elevated levels relative to historical norms for 20 out of 25 sectors. Thus, the inventory drawdown trend may continue through 2016.

Free Cash Flow Yield vs. Debt-Adjusted Cash Flow

Evaluations of a company's cash flow situation are important because cash is the fuel necessary for a company to expand its business, as well as the financial cushion a company has to weather adverse marketplace conditions. Commonly used cash flow metrics are free cash flow (FCF) and free cash flow yield. Free cash flow is calculated as operating cash flow, the cash generated by a company's regular business operations, minus capital expenditures (CAPEX). Free cash flow yield is a financial return ratio calculated by dividing free cash flow per share by a stock's share price. Free cash flow yield is frequently considered an alternative equity valuation metric to either the price/earnings (P/E) ratio or the earnings per share (EPS) metric.

Debt-adjusted cash flow provides a different perspective from that of free cash flow because it cancels out changes in the level of working capital a company has. By virtue of yielding a figure that is not affected by changes in working capital that can substantially skew cash flow figures, the debt-adjusted cash flow metric may provide a significantly different value indication than the free cash flow metric.

The formula for calculating debt-adjusted cash flow is as follows:

Debt-adjusted cash flow = cash flow from operations, minus the increase or decrease in working capital, plus after-tax net interest expenses.

The report points out a number of companies, including AMC Entertainment Holdings Inc. (NYSE: AMC) and PBF Energy Inc. (NYSE: PBF), that appear relatively inexpensive when evaluated by debt-adjusted cash flow, but expensive by free cash flow valuation. Looking at debt-adjusted cash flow may reveal such companies as hidden value stocks.

An Alternative Metric

Goldman Sachs recommends examining the EV/debt-adjusted cash flow metric, calculated as enterprise value divided by DACF, to help identify companies that show attractive valuations by that metric, but that may show unattractively high valuations by other commonly used metrics such as the P/E ratio or enterprise value divided by earnings before interest, taxes, depreciation and amortization (EV/EBITDA). Enterprise value is considered an alternative and more complete valuation than market capitalization, since it reflects market capitalization plus preferred equity, debt and minority interest, minus cash and investments.

By using an alternative metric that provides a fuller measure than market capitalization, and compared to a more efficient cash flow metric, investors can arrive at more accurate assessments of stock values. The report noted that, as compared to using free cash flow, debt-adjusted cash flow offers a good point of comparison with what Goldman Sachs states is its preferred return metric: cash return on capital invested (CROCI), which is equal to EBITDA divided by total equity value. Goldman Sachs has found the EV/debt-adjusted cash flow metric to be one of its most reliable value metrics from 2011-2016, used with a long/short equity strategy that has shown a 42% profit since May 2011.

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