Hi Investors. One of the most popular topics in company valuation is the Free cash flow. If you are involved in the fundamental analysis of stocks, you definitely have heard about this term.
Nevertheless, for beginners, free cash flow can be a mystery.
In this post, we are going to discuss what exactly is a free cash flow and why it is important to evaluate while researching a company. Here are the topics that we will cover in this post-
- What is a free cash flow?
- Why is free cash flow important?
- How to calculate free cash flow of a company?
- How to analyze the free cash flow?
This might be one of the most important articles for the people interested to learn stock valuations. Therefore, read this post completely. Let’s get started.
1. What is a Free Cash Flow (FCF)?
Free cash flow is the cash that is available for all the investors of the company. It represents the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base.
Now, you might be wondering what is so ‘FREE’ about this cash flow and how it is different from the earnings of the company?
Here you need to understand that not all income is equal to cash. If a company is making earnings, it doesn’t mean that it can spend all the income directly. The company can only spend the free cash. There is a crucial difference between ‘cash’ versus ‘cash that can be taken out of a business’, or in accounting terms: cash from operating activities and free cash flow (FCF).
The cash from operating activities is the amount of cash generated by the business operations of a company. However, not all of the cash from operating activities can be taken out of the business because some of it is required to keep the company operational. These expenses are called capital expenditures (CAPEX).
On the other hand, free cash flow is the cash that a company is able to generate after spending the money required to stay in business. This is the cash at the end of the year, after deducting all operating expenses, expenditures, investments etc and is available for distribution to all stakeholders of a company (Stakeholders include both equity and debt investors.)
2. Why is free cash flow important?
It’s important for an investor to look into the free cash flow of a company carefully because it is a relatively more accurate method to find the profitability of a company than the company’s earnings.
This is because earnings show the current profitability of the company. On the other hand, the free cash flow signals the future growth prospects of the company as this is the cash that allows the company to pursue opportunities to enhance shareholder’s value. Free cash flow reflects the ease with which businesses can grow or pay dividends to the shareholder.
The excess cash can be utilized by the company in expanding their portfolio, developing new products, making useful acquisitions, paying dividends, reducing debt or to pursue any other growth opportunity.
Further, free cash flow is also used as the input while calculating the intrinsic value of a company using the popular valuation technique- Discounted cash flow (DCF) Model.
(Besides, as free cash flow is the additional money that can be taken out of the company without affecting the running of the business, it is also called the “Owner’s Earnings”.)
3. How to calculate free cash flow of a stock?
Companies in the stock market are not obliged to publish their free cash flow. That’s why you can’t find FCF directly in the financial statements of the companies. However, the good point is that it is easy to calculate them.
To calculate the free cash flow of a stock, you’ll require its financial statements i.e income statement, balance sheet, and cash flow statements. There are two calculation methods to find Free cash flow of a company.
Method 1: From the Income statement & Balance sheet
FCF = EBIT (1-tax rate) +(depreciation & amortisation) -(change in net working capital) – (capital expenditure)
Method 2: From the cash flow statement
Free cash flow is calculated as cash from operations minus capital expenditures.
FCF = Cash flow from operating activities – capital expenditures (from the cash flow from investing activities)
Quick Note: To make the things simpler, SCREENER.IN has already made the free cash flow of the stocks available on their website. Feel free to check it out. Nevertheless, we advise our readers to do the calculations themselves to avoid any algorithm miscalculations.
4. How to analyze the free cash flow of a company?
While studying the cash flow of a company, it is important to find out where the cash is coming from. The cash can be generated either from the earnings or debts. While an increase in cash flow because of the increase in earnings is a good sign. However, the same is not true with debts.
Moreover, if two companies have a same free cash flow, it doesn’t mean that they have a similar future prospect. Few industries have a higher capital expenditure compared to other industries. Further, if the Capex is high, you need to investigate whether the reason for the high capital expenditure is due to expenses in growth or expenditure. In order to learn these, you have to read the quarterly/annual reports of the companies carefully.
Negative FCF of a company.
A consistently declining or negative free cash flow of a can be a warning sign for the investors. Negative free cash flow is dangerous because it leads to slow down in the business. Further, if the company didn’t improve its free cash flow, it might lead to the insufficient liquidity to stay in the business.
Quick Note: If you want to learn free cash flow and discounted cash flow (DCF) model in depth, feel free to check out this online course: HOW TO PICK WINNING STOCKS? Enroll now and learn stock valuation techniques today.
In this post, we discussed the Free cash flow (FCF). It is a measure of a company’s financial performance. Free cash flow represents how much cash a company has left from its operations i.e. the cash that could be used to pursue opportunities that improve shareholder value.
However, the absolute value of the free cash value doesn’t tell you the whole story. You have to find out where this cash is coming from and how the company is using it. Whether they are spending this money effectively on operations like giving healthy dividends, buybacks, acquisitions etc- or not. And finally, a consistent negative free cash flow of a company might be a warning sign for the investors.
That’s all for this post. I hope it was useful to you. Happy Investing!!