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.
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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.