Key Concept: Free Cash Flow
Free cash flow and discounted free cash flow are common terms in every value investing discussion. Here's a quick review of what they mean.
Free cash flow or FCF is a useful way of analyzing a company’s investment fundamentals. Let’s look at what it is, how to calculate it, and how to use it.
What Are Cash Flows?
Before discussing “free” cash flow, we need to look quickly at the concept of cash flow. There are two ways to measure a company’s profitability. One is earnings and the other is cash flow.
Earnings are synonymous with after-tax net income. They are the sum of sales, minus all the costs and expenses of the company.
Cash flow is, as the name suggests, the quantity of money entering and leaving the company.
The difference between the two is that earnings take into account ALL expenses, including accounting conventions like depreciation and amortization. In theory, this gives a more accurate view of a company’s profits. But this can also be used by unscrupulous management to temporarily make a picture look better than it really is.
In contrast, cash flow is a lot more straightforward. The money is in the company or not. But this does not always reflect real costs, like the infrequent need to purchase land, offices, or industrial equipment.
This is why Free Cash Flow is preferred when valuing a company.
How to Calculate Free Cash Flow
Free Cash Flow is Cash Flow minus Capital Expenditure (CAPEX).
FCF is especially useful in companies operating capital-intensive industries, like mining, oil & gas, or manufacturing.
A big advantage of free cash flow is that it reflects the company’s ability to distribute profit to the shareholders. Dividends are taken from actual cash, not accounting fictions like earnings or even worse metrics like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
Another advantage is that a difference between FCF and net income can reveal problems. Management’s calculation of depreciation may not have honestly measured the company’s regular CAPEX spending needs. This can give misleading high earnings for a little while, but the real CAPEX spending will be included in the FCF calculation, and show the true situation.
The Risks Of Using Free Cash Flow
Free Cash Flow is a useful way to evaluate a company. But like with all financial calculations, the devil is in the details.
One of the first things to check is to measure Free Cash Flow per share. If the company constantly issues new shares and dilutes existing shareholders, free cash flow growth will not profit the existing shareholders.
Another thing to pay attention to is CAPEX consistency. If the company spends capital very irregularly, the FCF calculation might be misleading. For example, if the company has paused CAPEX temporarily, this will boost FCF. But this CAPEX level is unlikely to be sustainable and will need to go up at a later date.
Lastly, capital allocation is important. A company can produce a lot of FCF, but squander it on ill-fated acquisitions, inefficient R&D, or unsuccessful expansion. In this case, the free cash flow is useless to shareholders, as it will never be distributed in the shape of dividends or buy-backs, or used to grow the business.
So overall, Free Cash Flow is useful if at least these 3 criteria are met:
Relatively stable share count.
Accurate estimation of future CAPEX needs and assessment of current CAPEX relative to the historical trend.
The company has a history of shareholder-friendly policy and good Return on Invested Capital (ROIC).
Any assessment of FCF has to start with establishing this basis.
Discounted Free Cash Flow
Discounted Free Cash Flow (DFCF) Analysis is a very popular valuation method widely used in value investing. It’s a complicated technique and a full explanation would require a much more detailed article, but we can look at the basic idea.
DFCF analysis uses the current free cash flow plus its expected growth over time and uses that figure to project the value of that cash flow in the future. That cash flow is “discounted”: for each future year, the current value of that future cash flow gets smaller.
The discount is designed to adjust for something called the time value of money. A dollar a year from now is less valuable than a dollar today because the dollar today can be used to earn more money over the course of the year. The discount rate is larger the farther into the future you project.
One of the principles of value investing is that a company’s legitimate value is the value of all its future cash flow, making DFCF analysis a very good way to judge if a stock is undervalued. This is especially useful for a company with plenty of growing FCF.
The limitations of this method fall into 2 categories:
Current Free Cash Flow may not reflect the true profitability of the company (see above.
Predictions about the future are hard, and the DFCF model can be very wrong if you misjudge the growth rate.
Growth rates may depend on external factors that are difficult to predict. Analysis of a company must be matched with an effective analysis of the industry and the wider economic environment.
DFCF analysis can be an effective tool, but to use it effectively you will need to study it at a level much deeper than this introduction. As with all analysis techniques, you’ll need to maintain awareness of its limitations.
Free Cash Flow (FCF) is a very useful tool to measure the long-term value of a company. Like all other tools, it needs to be used with a touch of common sense and good judgment.
In many circumstances, it is more relevant and gives a more accurate picture of a company’s profit than earnings. This is because earnings are easier to manipulate and are under more scrutiny by analysts. There is simply more incentive to optimize a company’s financials toward showing good earnings.
You will still need to be careful in your assessment of whether current and projected cash flow accurately represents the long-term prospects of the company. That means looking carefully at the company’s quality, its management’s skills and ethics, and the wider industry and economic environment.
Discounted Free Cash Flow models are as well useful, but vulnerable to error. They rely heavily on multiple assumptions about the future; especially growth rate and a stable economic environment. They can be used to evaluate a company’s current valuation, but should not be taken as an absolute truth about the company’s intrinsic value.
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This article originally appeared on FinMasters.com: What Is Free Cash Flow and How to Calculate It