Seven Free Cash Flow Kings

Stocks and bonds are different financial assets, of course--different in their levels of legal priority in the event of bankruptcy, and thus, different in their levels of risk. When a company goes bankrupt, its common stock is usually canceled and declared worthless, while bondholders usually get some portion of their original investment back. Even Enron bondholders were offered 14 to 18 cents on the dollar in that company's reorganization filing. That may not seem like much, but it's 14 to 18 cents more than the stockholders received.

Stocks and bonds are similar in one very large respect, however: Investors are paying for the right to receive the future cash flows thrown off by the investment. In the case of bonds, that cash comes in the form of interest. With stocks, the cash may come in the form of dividends (a bird in the hand) or retained free cash flow (two in the bush). (A caveat: If a company can't reinvest its cash at a decent rate of return, retained cash is worth less than if it were paid out as a dividend. This article explains why.)

For the stock investor, the possibility of "two in the bush" is especially important, so finding companies that are likely to grow their free cash flow over time is critical.

Interest Yield vs. Free Cash Flow Yield
With both stocks and bonds, investors are interested in the aftertax cash yield they'll receive relative to the risk of the investment. Ten-year Treasury bonds, which are free of default risk, yield about 4.2% (pretax) right now. Thirty-year risk-free Treasury bonds yield roughly 5% (pretax). That's low by historical standards, of course, and makes stocks look relatively attractive by comparison. For example, the average stock covered by Morningstar has a 4.1% free cash flow yield right now (free cash flow divided by current stock price). While this is a bit less than a comparable yield on long-term Treasuries, there are two big differences between the interest yield on a bond and the free cash flow yield on a stock.

First, the yield on a stock is (theoretically) inflation-protected. When inflation heats up, it does so because prices are rising. Prices rise because there is too much money chasing too few goods. During times like these, companies are able to raise prices on their products, and thus generate higher profits on their existing assets that were (theoretically) purchased at lower prices in years past.

Thus, free cash flow and inflation are correlated over the long term. That means the cash flow yield on a stock is a "real" yield--it's protected from inflation. By contrast, a Treasury or corporate bond is a "nominal" yield--it's not protected from inflation. (The exception being TIPS--U.S. Treasury Inflation-Protected Securities, which are indexed to inflation and thus have a "real" yield. Currently, that yield is 2.2%.) During times of inflation, most companies' cash flows rise and fall. On this measure, there isn't much difference between a company with no economic moat and one with a wide economic moat.

More important, though, is the fact that a stock's free cash flow yield grows over time as its earnings power grows. While a stock may yield only 4.1% today, over time, the free cash flow yield you'll receive on your original purchase price will presumably grow. For example, if a company grows its free cash flow 8% a year for 10 years, the cash yield you'll receive on your original purchase price will grow from 4.1% to 8.9%. By contrast, a bond's yield is fixed; what you see is what you get for the life of the bond.

The Wide-Moat Advantage
Of course, a company's earnings power will rise over time only if its competitive position and industry outlook stay the same or improve. Frequently, that will not be the case with no-moat companies. These companies have unsustainable competitive positions and may not even be around in 10 or 15 years.

Thus, to increase the odds that the real long-term cash flow yield of a company will rise, you need to focus on wide-moat companies. These companies enjoy sustainable competitive positions and reside in healthy industries. The odds are high that, over time, they'll increase their free cash flows faster than inflation.

I searched Morningstar's database to find some wide-moat stocks that currently have high free cash flow yields, based on 12-month trailing free cash flow and current stock price. Below are the results.

 H&R Block (HRB)
Free Cash Flow Yield: 11.6%
Morningstar Rating: 3 Stars

 General Dynamics (GD)
Free Cash Flow Yield: 7.6%
Morningstar Rating: 5 Stars

 McGraw-Hill Companies  (MHP)
Free Cash Flow Yield: 6.5%
Morningstar Rating: 4 Stars

 Automatic Data Processing (ADP)
Free Cash Flow Yield: 6.5%
Morningstar Rating: 4 Stars

 Fiserv (FISV)
Free Cash Flow Yield: 6.2%
Morningstar Rating: 4 Stars

 Equifax (EFX)
Free Cash Flow Yield: 6.2%
Morningstar Rating: 4 Stars

 First Data 
Free Cash Flow Yield: 6.0%
Morningstar Rating: 5 Stars

Not surprisingly, all but one of these is a 4- or 5-star stock. That's because our star rating is based on our estimate of the future risk-adjusted free cash flow yield of a stock. As long as the future free cash flow generation is expected to be close to that of the past, the trailing 12-month free cash flow yield of a 5-star stock will always be high.

The lone exception to this rule is H&R Block. It seems investors are worried about the company's mortgage business if interest rates rise, and about the risk of lawsuits that currently plague the company. Thus, investors are demanding a higher cash flow yield in order to buy H&R Block's stock. We've factored a somewhat pessimistic scenario into our fair value estimate, explaining the 3-star rating. A case could be made, though, that unless Armageddon comes, the stock is pretty cheap compared with its cash flow-generating ability.