Foolish Fundamentals: Free Cash Flow

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 gives an investor the insight 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. A company can generate plenty of free cash flow, but it might not actually hand it out for free -- companies do have to reinvest 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 Securities and Exchange Commission and in its annual reports. The formula is as follows:

Cash flow from operations
- capital expenditures
= free cash flow

You can see the math below. I have used Motley Fool Income Investor pick Constellation Energy Group (NYSE: CEG  ) as an example.

Free Cash Flow

FY 2004

FY 2003

FY 2002

Cash flow from operations

$1,086,800

$1,057,800

$1,005,800

- Capital expenditures

($703,600)

($635,700)

($817,700)

= Free cash flow

$383,200

$422,100

$188,100

Figures in thousands. Data provided by Capital IQ, a division of Standard & Poor's.

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 lets you peer into only 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 also that you 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 pays out a portion of its free cash flow as a dividend but doesn't pay 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 as true for currently unprofitable high-growth stories as it is for more mature companies. The only thing a stock price represents, after all, is the market's estimate of the future free cash flows that a business will generate.

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. There's no obligation to buy if you aren't completely happy.

Nathan Parmelee, Shruti Basavaraj, and Adrian Rush contributed to this article.


Read/Post Comments (5) | Recommend This Article (174)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 17, 2008, at 1:44 AM, sandeepkumarjha wrote:

    This article on FCF s too simplistic and does not consider lot of aspects.

  • Report this Comment On November 27, 2010, at 3:57 PM, mel4u2 wrote:

    please help compute free cash, i know it's simple and right there in front of me, but can't see to get it.

    WELLER COMPANY

    Statement of Cash Flows

    For the Year Ended December 31, 2011

    Cash flows from operating activities

    Net income $ 32000

    Adjustments to reconcile net income to net

    cash provided by operating activities

    Depreciation expense $ 14500

    Increase in accounts payable 14000

    Increase in accounts receivable -19000

    Increase in merchandise inventory -7000

    Decrease in income taxes payable

    -1000

    1500

    Net cash provided by operating activities 33500

    Cash flows from investing activities

    Sale of equipment 8500

    Cash flows from financing activities

    Issuance of common stock 4000

    Payment of dividends -25000

    Redemption of bonds

    -6000

    Net cash used by financing activities

    -27000

    Net increase in cash 15000

    Cash at beginning of period

    20000

    Cash at end of period

    $ 35000

    .

    Compute free cash flow.

  • Report this Comment On May 28, 2011, at 2:01 PM, AAAMPblog wrote:

    I prefer using Net Cash Flow instead of Free Cash Flow. Net Cash Flow is Profits + Non-Cash Expenses. This is the amount of money management has to reinvest, payoff debt, or return to shareholders. I have written an article on this subject at http://blog.arborinvestmentplanner.com/2011/05/what-is-net-c...

  • Report this Comment On January 09, 2014, at 12:53 AM, poiurt wrote:

    French based company is thinking to replace production equipment in Russia. New equipment will allow having annual cost saving in the amount of 180m Rubles for the next 7 years. Investments in the new equipment are 50m EUR. Market value of the existing equipment is 150m rub, but the book value is 235m rubles and 3 years of straight-line depreciation remaining. Corporate income tax rate in Russia is 20% and Ministry of Economy of Russia is expecting 6% inflation rate for the next 7 years. In France inflation is expected at 2% for the next 7 years. Financial analyst of French based company shall prepare investment analysis of this project. 11% of discount rate is used for the similar projects in France. Spot exchange rate is 40 Rubles per 1 EURO.

    1. Calculate free cash flows of the project in Rubles.

    2. Calculate free cash flows of the project in EUR.

    3. Calculate NPV in Rubles and EUR.

    Thanks, I appreciate it.

  • Report this Comment On January 16, 2014, at 11:44 AM, ak09aat wrote:

    I have the exact same question as @poiurt. Can you please help? Thanks!

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