If you are currently a shareholder in Red Hat Inc (NYSE:RHT), or considering investing in the stock, you need to examine how the business generates cash, and how it is reinvested. After investment, what’s left over is what belongs to you, the investor. This also determines how much the stock is worth. I will take you through Red Hat’s cash flow health and the risk-return concept based on the stock’s cash flow yield, using the most recent financial data. This will help you think about the company from a cash perspective, which is a crucial factor to investing.
What is free cash flow?Red Hat generates cash through its day-to-day business, which needs to be reinvested into the company in order for it to continue operating. What remains after this expenditure, is known as its free cash flow, or FCF, for short. I will be analysing Red Hat’s FCF by looking at its FCF yield and its operating cash flow growth. The yield will tell us whether the stock is generating enough cash to compensate for the risk investors take on by holding a single stock, which I will compare to the market index. The growth will proxy for sustainability levels of this cash generation.
Free Cash Flow = Operating Cash Flows – Net Capital Expenditure
Free Cash Flow Yield = Free Cash Flow / Enterprise Value
where Enterprise Value = Market Capitalisation + Net Debt
Along with a positive operating cash flow, Red Hat also generates a positive free cash flow. However, the yield of 2.69% is not sufficient to compensate for the level of risk investors are taking on. This is because Red Hat’s yield is well-below the market yield, in addition to serving higher risk compared to the well-diversified market index.
Does Red Hat have a favourable cash flow trend?Another important consideration is whether this return is likely to be maintained over the next couple of years. We can gauge this by looking at Red Hat’s expected operating cash flows. In the next few years, a double-digit growth in operating cash of 24.16% is expected. The future seems buoyant if Red Hat can maintain its levels of capital expenditure as well. Below is a table of Red Hat’s operating cash flow in the past year, as well as the anticipated level going forward.
|Current||+1 year||+2 year|
|Operating Cash Flow (OCF)||US$1.01b||US$1.09b||US$1.26b|
|OCF Growth Year-On-Year||7.56%||15.44%|
|OCF Growth From Current Year||24.16%|
Although its positive operating cash flow, and high future growth, is appealing, the low free cash flow yield is unattractive. This is because you would be better compensated in terms of cash yield, by investing in the market index, as well as take on lower diversification risk. However, cash is only one aspect of investing. Now you know to keep cash flows in mind, I recommend you continue to research Red Hat to get a better picture of the company by looking at:
- Valuation: What is RHT worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether RHT is currently mispriced by the market.
- Management Team: An experienced management team on the helm increases our confidence in the business – take a look at who sits on Red Hat’s board and the CEO’s back ground.
- Other High-Performing Stocks: If you believe you should cushion your portfolio with something less risky, scroll through our free list of these great stocks here.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.