Free cash flow is up but prices are down

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S&P 500 free cash flow (FCF) still high, but falling[1],[2]. The final yield of FCF also remains high, compared to recent quarters, as stock prices fall more than FCF. I think the market is signaling expectations for further declines in FCF, and I expect prices to continue lower until FCF hits bottom.

This report is an abridged version of S&P 500 & Sectors: Free Cash Flow Is Up But Prices Are Down, one of my quarterly series on fundamental market and sector trends.

FCF performance increases over the past year

2021 has been a very profitable year for the S&P 500. The FCF yield of the S&P 500 fell from 1.6% on 6/30/21 to 2.2% on 5/16/22. The S&P 500’s FCF yield has only been as high three other times since the start of 2015: 6/30/16, 12/31/18 and 3/31/22.

Seven sectors of the S&P 500 recorded an increase in FCF performance from 6/30/21 to 5/16/22.

Key details on selected S&P 500 sectors

The Energy sector has the highest FCF yield at 5.0% as of 05/16/22. On the other hand, the real estate sector, at -4.4%, currently has the lowest FCF yield of any sector in the S&P 500.

The Telecommunications Services, Energy, Utilities, Financials, Healthcare, Consumer Staples and Consumer Discretionary sectors each saw an increase in FCF performance as of 6/30/ 21 to 16/05/22.

Below, I highlight the telecommunications services sector, which saw the greatest year-over-year improvement in FCF performance.

Example of sector analysis: telecommunications services

Figure 1 shows that the mobile FCF return for the telecommunications services sector fell from -5.3% on 6/30/21 to 2.6% on 5/16/22. Telecom Services sector FCF increased from -$86.9 billion in 1Q21 to $37.3 billion in 1Q22, while enterprise value increased from $1.6 trillion in 30/ 06/21 to $1.4 trillion as of 05/16/22.

Figure 1: Telecom Services FCF Return: December 2004 – 5/16/22

The May 16, 2022 measurement period uses price data as of that date and incorporates 1Q22 10-Q financial data, as this is the earliest date for which all 1Q22 10-Qs for components of the S&P 500 were available.

Figure 2 compares FCF and enterprise value trends for the telecommunications services sector since 2004. I add up the individual S&P 500/sector constituent values ​​for free cash flow and enterprise value. I call this approach the “global” methodology, and it matches the S&P Global (SPGI) methodology for these calculations.

Figure 2: Telecom Services FCF and Enterprise Value: December 2004 – 05/16/22

The May 16, 2022 measurement period uses price data as of that date and incorporates 1Q22 10-Q financial data, as this is the earliest date for which all 1Q22 10-Qs for components of the S&P 500 were available.

The Aggregate Methodology provides a simple view of the entire S&P 500/sector, regardless of market capitalization or index weighting, and is the way S&P Global (SPGI) calculates metrics for the S&P 500.

For additional perspective, I compare the Aggregate method for free cash flow with two other market-weighted methodologies: market-weighted measures and market-weighted drivers. Each method has its advantages and disadvantages, which are detailed in the appendix.

Figure 3 compares these three methods of calculating the rolling FCF returns of the telecommunications services sector.

Figure 3: Telecom Service FCF Yield Methodologies Compared: December 2004 – 5/16/22

The May 16, 2022 measurement period uses price data as of that date and incorporates 1Q22 10-Q financial data, as this is the earliest date for which all 1Q22 10-Qs for components of the S&P 500 were available.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, style, or theme.

Annex: Analysis of the final yield of the FCF with different weighting methodologies

I get the above metrics by adding the individual S&P 500/sector constituent values ​​for free cash flow and enterprise value to calculate the final FCF yield. I call this approach the “Aggregate” methodology.

The Aggregate Methodology provides a simple view of the entire S&P 500/sector, regardless of market capitalization or index weighting, and is the way S&P Global (SPGI) calculates metrics for the S&P 500.

For additional perspective, I compare the Aggregate method for free cash flow with two other market-weighted methodologies. These market-weighted methodologies add more value for ratios that don’t include market values, e.g. ROIC and its drivers, but I’m including them here nonetheless, for comparison:

Market-weighted measures – calculated by market capitalization weighting the return of FCF for individual companies relative to their sector or the entire S&P 500 in each period. Details:

  1. The weight of the company is equal to the market capitalization of the company divided by the market capitalization of the S&P 500/its sector
  2. I multiply the FCF yield of each company by its weight
  3. The FCF return of the S&P 500/sector is equal to the sum of the weighted FCF returns of all the companies in the S&P 500/sector

Market-weighted drivers – calculated by weighting by market capitalization the FCF and the enterprise value for the individual companies of each sector in each period. Details:

  1. The weight of the company is equal to the market capitalization of the company divided by the market capitalization of the S&P 500/its sector
  2. I multiply each company’s free cash flow and enterprise value by its weight
  3. I sum the weighted FCF and the weighted enterprise value for each S&P 500 company/each sector to determine the weighted FCF and the weighted enterprise value of each sector
  4. The return of the S&P 500/sector backward FCF is equal to the S&P 500/sector FCF weighted by the weighted enterprise value of the S&P 500/sector

Each methodology has its pros and cons as listed below:

Aggregate method

Advantages:

  • A direct view of the entire S&P 500/sector, regardless of company size or weighting.
  • Corresponds to how S&P Global calculates metrics for the S&P 500.

The inconvenients:

  • Vulnerable to the impact of companies entering/leaving the corporate group, which could unduly affect overall values. Also sensitive to outliers over a period of time.

Market-weighted measures method

Advantages:

  • Considers a company’s market capitalization relative to the S&P 500/sector and weights its metrics accordingly.

The inconvenients:

  • Vulnerable to outlying results that disproportionately impact overall FCF performance.

Market-weighted factor method

Advantages:

  • Considers a company’s market capitalization relative to the S&P 500/sector and weights its free cash flow and enterprise value accordingly.
  • Mitigates the disproportionate impact of a company’s outlying results on overall results.

The inconvenients:

  • More volatile as it emphasizes large changes in FCF and enterprise value for heavily weighted companies.

[1] I calculate these metrics based on the S&P Global (SPGI) methodology, which sums the individual S&P 500 constituent values ​​for market capitalization and economic book value before using them to calculate the metrics. This is what I call the “aggregate” methodology.

[2] This research is based on the latest audited financial data, which is 1Q22 10-Q for most companies. Price data is as of 05/16/22.

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