The S&P 500 may look expensive on most traditional valuation metrics, however, according to Goldman Sachs due to a record low level of capital spending; the index appears attractive when valued on free cash flow yield.

Indeed, according to a recent research report from the investment bank, capital expenditure as a percentage of cash flow from operations ranks in just the fifth historical percentile since 1990.

The report goes on to argue that valuing companies according to free cash flow yield minus capital spending gives a more reliable indicator of value, as companies that have a high free cash flow yield often appear attractively valued because they minimize CapEx. Therefore the numbers present a better picture than they otherwise would.

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Goldman: Free Cash Flow Yield Worthless

For example, the report notes that today the free cash flow yield for the S&P 500 is currently 4.2%, near the average since 1990. However, this metric is misleading because companies have slashed CapEx to boost profits. On all other metrics, the index is overvalued, which only highlights further this accounting trick. The percentage of free cash flow invested in operations has fallen to 47% between 2002 and 2017, down from 69% between 1990 and 2002. According to Goldman’s calculations, the decline in the CapEx investment ratio (capital spending/cash flow from operations) accounts for almost 40% of free cash flow growth over the past 25 years. “Every dollar of CFO not spent on CapEx is accretive to current year FCF” the report notes. “Since 1990, S&P 500 CFO has increased by an average of 6.7% per year compared with an increase of 10.8% per year for FCF. The 4.1 pp difference in growth has been driven by firms retaining more of CFO instead of investing it in CapEx ,” the analysts summarize.

Free Cash Flow Yield

To try and help distinguish between those companies that are cheap based on cash flow generated from operations, and those that have cut capital spending aggressively to increase cash flow in the near-term, at the expense of long-term growth, Goldman introduces the “adjusted free cash flow yield” measure that takes into account free cash flow as well as capital spending and research and development spending to come up with a more accurate measure of company value. The adjusted free cash flow metric is calculated as follows: (free cash flow + growth CapEx + R&D)/market capitalization.

Free Cash Flow Yield

This adjusted measure is designed work out the drawbacks of traditional free cash flow. Free cash flow penalizes asset heavy businesses but gives credit to pharmaceutical companies whose investment is predominantly in R&D rather than capital spending.

Free Cash Flow Yield

Back testing shows that such an approach has achieved results over the past two and half decades:

“A 25-year back test supports our view that investing in stocks with the highest vs. lowest adjusted FCF yields is a successful long-term strategy. An adjusted FCF yield strategy has outperformed a similar traditional free cash flow yield  strategy by 3 pp per year since 1990. However, the strategy has outperformed traditional free cash flow yield by 6 pp per year since June 2009 as investors have become more concerned with companies’ future growth prospects in a secular stagnation economy.”

This adjusted free cash flow ratio could be helpful for value investors seeking the market’s best cash cows. For growth investors, seeking the companies with the highest reinvestment rates, Goldman recommends using the adjusted free cash flow formula: (total CapEx -depreciation + R&D)/ cash flow from operations. In Goldman’s basket of 50 companies that have invested the most in future growth within the S&P 500, the median investment ratio is 90% since 2014 vs. 18% for the median S&P 500 company.

Free Cash Flow Yield free cash flow yield

The companies in the S&P 500 with the highest adjusted free cash flow yield according to Goldman are: Ford Motor Co. (52%), Tyson Foods Inc.(11%), Valero Energy Corp (10%), Gilead Sciences (20%), American Airlines Group (19%), Seagate Technology (22%) and LyondellBasell Industries (13%).

Autodesk Inc, CF Industries Holdings, American Airlines Group, Incyte Corp., Netflix Inc. and General Motors have the highest reinvestment rates in the S&P 500.