Why is Free Cash Flow NOT always a good metric to analyse a company?

This might take less than 3 minutes of your precious time. But do give it a read.

It is said that Cash is the King! Undoubtedly! But does that mean that a company not generating Free Cash flow is a bad company to invest in? Probably Not!

You shall hear numerous fund managers saying that Free Cash flow (FCF) is the first metric to look for while investing in a company. For all those who don't know, Free Cash flow refers to the Cash flow that remains with the company after meeting the capex needs of the business. Companies generating Free Cash flows get superior valuations in the Stock markets. But what if your company is not generating Free Cash flows? There may be numerous reasons for it. One of them is the formula itself. According to Investopedia, Free Cash flow is calculated as :

EBIT (1-tax rate) + Non Cash expense -Working Capital changes - Capex

Focus on 'Capex'. There are basically 2 types of Capex - Growth capex and Maintenance capex. While calculating FCF, you should surely deduct Maintenance capex to arrive at the FCF for the company. But the catch lies in the Growth capex. What if the company has identified a superior opportunity that shall boost the returns of the company in the future to an exponential level? In such a scenario a company shall surely look for utilizing Internal accruals or may even raise more debt to fund the capex. Should it let the opportunity go and rather invest in a FD just to boost the FCF of the company?

No, right? Sometimes, companies find excellent investment opportunities that may curb the return ratios in the short term but shall boost the long term earnings of the shareholders. Due credit should be given to the management of those companies. Hence look for the underlying nature of the capex. If the capex is expected to bring growth for the company, analyse the opportunity in the context of broader scheme of things before simply avoiding it based on the fact that it is not generating FCF. Growth capex may not be deducted to arrive at the FCF for the company if you feel that the underlying opportunity is expected to boost the return ratios of the company to an exponential level.

I hope I was able to convey my thoughts well. You can check in Rohit Chauhan's tweet discussing the same (here) Send me your feedback on [email protected] or DM me on Twitter @Sharedalal_

Happy Investing!

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