Free Cash Flow

Here's why investors use free cash flow to better understand a company's profitability.

Oct 9, 2015 at 2:03PM

Free cash flow can be a tremendously useful measure for understanding the true profitability of a business. It's harder to manipulate and it can tell a much better story of a company than more commonly used metrics like net income.

Why use free cash flow?
You may have heard someone say that "you can't pay your bills with net income." Whether we're talking salaries, utility bills, construction on a new factory, or dividends, it's all paid in cash. Thus, it's the business's ability to generate cash that really matters.

One of the weaknesses of the income statement is that it spreads out the cash spent on long-term investments over time. For example, if Microsoft buys $1 billion in computer equipment, the expense is spread out over 2-3 years on its income statement in the form of depreciation. However, Microsoft doesn't get to spread out the actual cash payment for computer equipment over 2-3 years. It pays for computer equipment up front, and in cash.

Stated simply, the income statement is designed to smooth out a business's uses of cash over time. The cash flow statement, from which free cash flow is calculated, offers no such smoothing benefit. It's all about the here and now.

Calculating free cash flow
There are several methods for calculating free cash flow, but reporting requirements make it really easy to calculate for publicly traded companies. To calculate it, all you need to do is turn to a company's statement of cash flows and use the following formula:

Cash flow from operations-capital expenditures = free cash flow.

Typically, because of the volatility in free cash flow, you'll find that it's best to observe free cash flow over a period of a few years rather than a single year or quarter.

What free cash flow can tell you
Companies that are capital light, meaning they don't have to make long-term investments as part of their business, will have very steady free cash flow over time. Free cash flow for a capital-light business will usually approximate net income. Companies that do have to make big long-term investments -- building factories or buying bulldozers, for example -- will have more volatile free cash flows.

Look at Moody's, a company for which the brainpower of its employees is its major product. You'll notice that it produces very stable free cash flow over time, and that its free cash flow roughly approximates its net income from year to year. This is because it is a very capital-light business. To grow, Moody's doesn't have to build billion-dollar factories. Rather, it hires more employees whose salaries are paid as services are produced and sold.

Conversely, Chevron has historically generated volatile free cash flows because it has to make large, billion-dollar investments in machinery and equipment to bring oil and gas to the ground. (The fact that oil prices rise and fall certainly doesn't help reduce the volatility in its free cash flow, either!)

The maturity of a business will also affect free cash flow. Mature businesses generally produce more consistent free cash flow, because they aren't making continuously large investments to grow.

Younger companies typically produce little in the way of free cash flow, because the cash they generate from operations is put back into the business. (As an example, refer to Wal-Mart's statements of cash flows from 1998 to 2000 and compare them the statements from 2013 to 2015. You'll see that its slowing growth has resulted in significantly more free cash flow as a percentage of cash flow from operations.)

For banks, insurers, and other financial companies, you can essentially throw out free cash flow altogether. It's simply not useful in the same way it is for non-financial companies.

Free cash flow in valuation
Many people use free cash flow as a substitution for earnings when valuing businesses that are mature, capital light, or both. Like price-earnings ratios, price-to-free-cash-flow ratios can be useful in valuing a business. To calculate a price-to-free-cash-flow ratio, you can simply divide the price of a share by the free-cash-flow per share, or the market cap of a company divided by its total free cash flow.

Ultimately, free cash flow is just another metric, and it doesn't tell you everything, nor will it be useful for every kind of company. But observing that there is a very big difference between income and free cash flow will almost certainly make you a better investor.

The next billion-dollar iSecret
The world's biggest tech company forgot to show you something at its recent event, but a few Wall Street analysts and the Fool didn't miss a beat: There's a small company that's powering their brand-new gadgets and the coming revolution in technology. And we think its stock price has nearly unlimited room to run for early in-the-know investors! To be one of them, just click here.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus . Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us atknowledgecenter@fool.com . Thanks -- and Fool on!

Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers