The Underappreciated Metric That Spotlights Bargain Stocks

We live in a yield-obsessed era.

Whether it's dividend yields, junk bond yields or lowly government bond yields, investors seek yields in every corner of the market.

But many overlook the most important type: free cash flow yield. It's a simple yet powerful measure that points to the market's top bargains. And you should measure each stock in your portfolio against this underappreciated metric.

You can figure out this yield by identifying a company's annual free cash flow (which is its operating cash flow minus its capital spending) and dividing it by the company's market value. For example, a company with $50 million in free cash flow and a $1 billion market value has a 5% free cash flow (FCF) yield ($50 million/$1 billion).

Most companies in the S&P 400 (a mid-cap index), S&P 500 and S&P 600 (small caps) have FCF yields below that 5% threshold, yet any time you see a figure that's higher, it's a certifiable value. In recent years, I've cited Wal-Mart Stores (NYSE: WMT) as an example of a compelling FCF yield. The giant retailer has stumbled during the past half-decade, but whenever its stock falls out of favor, value investors have swooped in and purchased, thanks to that solid FCF yield.

Why is free cash flow so important? It's the only way you can know whether a company is adding value and building up cash levels, even after capital spending has been taken into account. Any company with $100 million in profits and $200 million in capital spending is bleeding cash, not building it.

The double-digit yielders
Yet 5% is impressive though unspectacular when you consider that 44 out of 1,500 companies noted in those S&P indexes (400, 500, 600) sport FCF yields in excess of 10%. In this multi-part look at companies with high FCF yields, I'll look at the best small caps, mid caps and large caps. First, let's look at the small caps.

A quick screen of small caps will help us pin down 22 companies that sport FCF yields above 10%. In fact, a handful of them have yields above 20%, which is remarkable. But looks can be deceiving. Some of these firms managed to generate solid free cash flow in 2012, but their longer-term track record is spotty. I've run through the list of 22, eliminating any firms that haven't had positive free cash flow for three straight years, and narrowed the list considerably.

Take Interactive Brokers Group (Nasdaq: IBKR). The provider of online trading services has been remarkably profitable, though it has a red flag: Free cash flow has fallen from $1.6 billion in 2010 to $474 million in 2012.

Some of the drop is attributed to falling interest rates, as Interactive must charge lower rates for the margin loans it provides to clients. Yet the primary challenge to the business model has been in its market-making business (market makers hold an inventory of shares in certain stocks and buy and sell them to investors according to demand). Profit margins for all market makers have come under pressure in recent years, thanks to the advent of other trading platforms such as electronic communications networks, which are increasingly favored by many mutual fund and hedge fund managers.

Yet even as the market-making business (which accounted for one-third of profits in 2012) will likely come under further pressure, the online brokerage platform (which was recently ranked first by Barron's in its annual survey) looks set to deliver solid free cash flow as the base of assets managed by customers has been rising at 25% annually, exceeding $30 billion. That should help to generate higher margins once interest rates rise. Even if Interactive’s annual free cash flow falls to $200 million in coming years, its stock is a compelling bargain.

This firm provides asset management services to institutions and high-net-worth individuals. Its recent financial performance has been underwhelming in recent years, thanks in part to a conservative investment approach that was out of sync with the bull market during the past four years.

Still, asset management is a steady and profitable business, and Calamos has generated at least $100 million in free cash flow in each of the past nine years.