Why Free Cash Flow Matters

We talk about free cash flow a great deal around here and with good reason. It is the gold standard by which to measure the profitability of a company's operations. Free cash flow is not perfect, but it is more difficult to manipulate than net income or earnings per share (more on this later). For this reason, it is also likely to be lumpier than net income.

Caveats aside, free cash flow is my favorite metric when evaluating a company, because of the insight it gives an investor as to how heavy or light a company's business model is and how clearly it shows a company's ability to reward investors.

What is free cash flow?
Free cash flow is not free in the traditional sense of the word. FactsetResearch Systems (NYSE: FDS  ) generates plenty of free cash flow, but the company isn't actually handing it out for nothing and companies do have to invest in their businesses to generate free cash flow. That said, free cash flow is what a company has left over at the end of the year -- or quarter -- after paying for all the salaries, bills, interest on debt, and taxes and after making capital expenditures to expand the business.

A real-life example
Free cash flow is unbelievably easy to calculate and both of the pieces you need to make the calculation can be found on the statement of cash flows. Every company provides this statement in its 10-Q and 10-K filings with the SEC and in their annual reports. The formula is: cash flow from operations - capital expenditures = free cash flow. You can see the math below. I have used Heinz (NYSE: HNZ  ) as an example.

Free Cash Flow
($ in thousands)

2005

2004

2003

Cash Flow From Operations

1,160,793

1,249,007

906,038

- Capital Expenditures

(240,671)

(231,961)

(153,969)

= Free Cash Flow

920,122

1,017,046

752,069



In its most basic form -- and sometimes this is all that's necessary -- that is a free cash flow calculation. You can make the calculation more sophisticated by backing out one-time items and removing any benefits a company is receiving from stock options and counting as an operational benefit. (Hint: They're not operational.) But starting with the most basic calculation and looking over a period of four to five years will give you a good idea of how well a business has performed.

It's what you do with it that counts
As great as it is to find a company with strong free cash flow, the metric itself really only lets you peer into the operational profitability of a business. What a company does with its free cash flow is just as important as having it in the first place. Companies that simply hoard their cash or spend it aimlessly on acquisitions will likely do more harm than good to your portfolio.

As an investor, you're much better served to look for companies that take their free cash flow and put it toward share repurchases when their shares are below their intrinsic value or, better yet, toward a regular cash dividend. The beauty of being an income investor and receiving a cash dividend is not only that you get a guaranteed tangible return, but that you also have the option to reinvest the money received in more shares of the same business or another opportunity. The point is that you get to decide how the cash is allocated.

Just make sure that the company is like ExxonMobil (NYSE: XOM  ) , which pays out a portion of its free cash flow as a dividend, and not like ConAgra (NYSE: CAG  ) , which pays out more in dividends than it generates in free cash flow.

Foolish final words
As investors, we all want companies that generate or will eventually generate free cash flow. This is equally true for currently unprofitable high-growth stories such as Sirius (Nasdaq: SIRI  ) and XM Satellite Radio (Nasdaq: XMSR  ) as it is for more mature companies such as Alcoa (NYSE: AA  ) or Wendy's (NYSE: WEN  ) . This is because all a stock price represents is the market's estimate of the future free cash flows a business will generate. As someone who has adopted an income-investing strategy, I prefer to choose companies that currently generate free cash flows and that either pay a dividend or are likely to pay a dividend, because I've yet to find a better indicator of a solid business than a dividend funded by ample free cash flow.

Heinz is a Motley Fool Income Investor selection. If you're interested in learning more about companies that generate robust free cash flow and pay you to hold them,consider afree 30-day trialto Motley Fool Income Investor. Over the past two years, lead analyst Mathew Emmert has delivered an average total return of 17.4% against the S&P 500's 10.8%. There's no obligation to buy if you aren't completely happy.

NathanParmelee beneficially owns shares in Heinz, but has no financial interest in any of the other companies mentioned. You can view his profile here. The Motley Fool has an ironclad disclosure policy.


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