Joy of Free Cash Flow

"Free cash flow." That has the ring of something everyone should want. Break it down into its parts.

Free. Who can argue with free?

Cash. Ah, crisp new cash -- a printed ticket to opportunity.

Flow: a consistent happening. Put it all together and what do you have? A flow of free cash.

Great! Where do I sign up?

We celebrate free cash flow (FCF) all across The Motley Fool because it is the most important thing that a public company can accomplish. Lacking free cash flow, it's difficult for a business to pursue new opportunities, acquire other businesses, or pay dividends. When achieving free cash flow, a company is much more capable of those things plus paying down debt, saving cash for a rainy year, and building shareholder equity. So, what exactly is free cash flow?

Free cash flow explained
Free cash flow is money earned from operations that a business can actually put into its proverbial savings account after all is said and done. Free cash flow is cash from operations (also called operating cash flow) minus capital expenditures, which are investments in property, plant, and equipment. The formula for finding free cash flow is this easy:

FCF = Operating Cash Flow (OCF) - Capital Expenditures

The numbers needed to calculate free cash flow reside on the cash flow statement. A company's cash flow statement is vitally important, so it's ironic that it's the statement least scrutinized by analysts on Wall Street. Analysts obsess over a company's income statement and its little earnings per share number. But analysts pay much less attention to the balance sheet -- Enron (OTCBB: ENERQ) never provided a balance sheet in a timely fashion and only one analyst vocally complained -- and they give even less vocal analysis to the cash flow statement.

This is wrong. Analysts' coveted income statements do not provide a clear picture of a company's results. The income statement is typically clouded by interest earned or paid, fluctuations in tax rates, one-time events, and numerous distorting but (as yet) legal accounting maneuvers. By contrast, the cash flow statement isn't Mother Teresa, but it still gives investors a much clearer view of a company's cash generating (and keeping!) capabilities. And that's what's important.

Free cash flow example
Drip Port has never invested in a company that isn't achieving growing free cash flow. That wouldn't be our style. (Rule Breaker investors buy companies that lack free cash flow, but they hope for substantial free cash flow down the road.)

You can find a company's cash flow statement in its SEC files, available from Fool Quotes & Data.

One thing to remember as you look at a cash flow statement is that it is cumulative. A cash flow statement contains results for the year thus far. To see an entire year's results, just draw up the annual results and use the above formula on the year-end cash flow statement. To see a quarter's results, you  need to use simple math. For example, you need to subtract the second quarter's cash flow numbers from the third quarter's to see the third quarter's results alone. Using Johnson & Johnson (NYSE: JNJ), here's an example:

Q3 2001 Cash Flow Statement
OCF�������.............$6.068 billion
Capital expenditures�....$978 million
FCF�������.............$5.090 billion

Q2 2001 Cash Flow Statement
OCF�������.............$3.926 billion
Capital expenditures�....$571 million
FCF�������.............$3.355 billion

Q3's FCF�����..... ....$1.735 billion

Numbers to exclude and other dragons
Ah, but nothing financial is so simple. You'll often need to consider more than just operating cash flow and capital expenditures to find an accurate free cash flow figure. Even on the cash flow statement, impure numbers can seep in and cloud results. For example, you should deduct tax benefits from stock options from operating cash flow because it isn't a true gain from operations.

If a company lists its tax benefits from stock options on its cash flow statement your work is easy (and all companies should, just as eBay (Nasdaq: EBAY) does since the Fool's Brian Lund called them on it). Unfortunately, most companies don't list it, so you'll need to scour the financials for the right tax benefits figure to deduct from operating cash flow.

You should also consider deducting one-time gains, deferred income taxes, and other results not directly related to normal operations, as explained in a "Fool on the Hill" column on free cash flow. 

Such adjustments can make figuring free cash flow more complex than need be. If you're overwhelmed, start by just using the simple formula above to find a company's "unrefined" free cash flow. For many large, stable companies, the other "dragons" in the numbers are often not large enough to matter significantly. So, you can still get an accurate gauge of free cash flow growth with just the simple formula. However, when you're ready, hunt down the dragons, especially tax benefits from stock options, to arrive at refined free cash flow. Then start tracking it at your companies.

Enterprise value to free-cash-flow valuation
Last week, we reviewed enterprise value (EV). Once you have free cash flow results for a year, you can value a company on an enterprise-value-to-free-cash-flow basis (as we did earlier this month). If Johnson & Johnson has $172 billion in enterprise value and $7.2 billion in free cash flow, it trades at 23.8 times free cash flow. The EV/FCF ratio is much more reliable (and meaningful) than the P/E, which is often distorted. J&J's P/E is around 30.

Jeff "half-man, half-ape" Fischer is on a leave of absence. This column was written in advance, so he isn't able to answer e-mail. For Drip or other questions, please visit Fool's School, the Community, or e-mail [email protected]. The author owns Drip Port's stocks, eBay, and others. The Fool has a disclosure policy.