Free cash flow - the wealth creation measure

We are going to look at how to calculate and use free cash flow.

Free cash flow is one of the most important measures in a business. Over time, if free cash flow goes up, so does the value of the business.

Although free cash flow is often mentioned, it is less often used. Because it is not a number that you can look up on the financial statements. You have to calculate it.

Free cash flow is the best measure of the value of your business

The benefits of understanding free cash flow are:

• It shows if the business is increasing in value.
• You can compare it across businesses.
• You can calculate it for stocks or for your own business.

What is free cash flow?

The first thing to know is that there are two types of free cash flow:

1. Free cash flow to the firm (FCFF)
2. Free cash flow to equity (FCFE)

Most of the time when you hear people talking about free cash flow, they mean FCFF. That is the one we are going to focus on.

FCFF is the cash that a company generates in a year. It takes into account all the cash coming in and all the cash going out, including cash reinvested into the business. FCFF is the cash that the company has left to pay down debt and to pay dividends.

The reason it is called Free Cash Flow to the Firm is because it is not only the owners cash, it also contains the cash that has to be paid to lenders.

FCFE is slightly different, this is the amount available to the owners after debt has been increased or reduced.

Calculating free cash flow

You can calculate FCFF from net profit as follows:

FCFF = net profit after tax + [interest paid x (1 - Tax rate)] + non-cash charges - working capital changes - capital expenditures

That is a long formula. Thankfully, there is a shortcut.

The cash flow statement contains a line called Cash Flow from Operations (CFO) and that takes into account most of the above formula.

You can calculate FCFF from CFO as follows:

?FCFF = cash flow from operations - capital expenditures

This is quite easy and only requires two numbers. Both of those can be found in the cash flow statement.

Capital expenditures (or capex for short) is the amount a company spends to buy or maintain fixed assets (i.e. buildings, equipment, computers, vehicles, machines, etc).

How is free cash flow used?

FCFF is used to pay lenders and shareholders. It can also be used for new investments. Remember, FCFF already takes into account capital expenditures, so reinvestment in the business is already covered.

Free cash flow is used for things, such as:

• Repaying debt. This usually has to be done first because debtholders are senior in their claims versus other providers of finance, such as shareholders.
• Mergers & Acquisitions. The company can buy another business
• Share?buybacks. The company can buyback its own shares.
• Dividends. The company can pay dividends to the owners of the business.

At different times each of these will be prioritised. For instance, a young and growing company will usually be re-investing heavily and therefore will have little free cash flow left over. More mature companies may use their free cash flow to engage in M&A and to pay dividends. Share buybacks also happen quite often.

Free cash flow ratios

Here are some simple free cash flow ratios to measure business performance and valuation.

Free cash flow margin

This shows what percentage of sales ends up as free cash flow. A higher percentage is better.

Free cash flow margin = FCFF / Sales

Apple’s free cash flow margin = 111 443 / 394 328 = 28%

Free cash flow conversion

Net profit after tax does not equate to cash earned. However it is quite handy to see how much net profit ends up in cash. A higher percentage is better.

Free cash flow conversion = FCFF / Net Profit After Tax

Apple’s free cash flow conversion = 111 443 / 99 803 = 116%

Free cash flow yield

This shows the ratio of free cash flow per share to the share price. It can be compared to other company yields to determine if a stock is expensive or not. The higher the yield, the less expensive the stock.

Free cash flow yield = FCFF per share / Share Price

Free cash flow yield = 6.99 / 138.20 = 5.1%

Stock-based compensation

Beware of Stock-Based Compensation (SBC). This includes things such as share options, restricted stock and performance shares. Basically, these are different forms of payment to employees using shares instead of cash.

The problem with this is that the payment does not end up as a cash expense. Therefore FCFF does not reflect the compensation paid to employees.

To address this, FCFF (and FCFE) should be adjusted. The way to adjust them is to subtract SBC from them.

Adjusted FCFF = FCFF - SBC

Apple’s Adjusted FCFF = $111 443 - $9 038 = $102 405 million

Conclusion

So next time you hear about free cash flow, remember people are usually talking about free cash flow to the firm (FCFF). You can use free cash flow to analyse stock investments or to measure what is happening in your own business.

In general you want to see steadily increasing free cash flow over time. But there will be years that it goes down, particularly when a company is reinvesting for growth.

That is why it is important to understand the context. Free cash flow dropping in the short-term can mean larger free cash flows in future.

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