Joy of Free Cash Flow

We're celebrating our 10-year anniversary this month and bringing back some blasts from the past. Free cash flow is near and dear to our hearts as Fools, so today we offer up this classic from Jeff Fischer, which originally ran on February 28, 2002.

"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 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, building shareholder equity, and giving to charity. 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 seems to be 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 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
Many Fools rarely invest in a company that isn't achieving growing free cash flow, or about to start. 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 past results from Johnson & Johnson (NYSE: JNJ), here's an example:

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.

Valuing all that cash
Once you've determined free cash flow, finding a stock's valuation is as easy as measuring its market value (which is shares outstanding multiplied by stock price) to its free cash flow. For example, last year, Johnson & Johnson achieved about $7 billion in free cash flow and traded at a market value of $160 billion. That priced the company at 22.8 times free cash flow. As of July 2003, the S&P 500 was at 22.7 times free cash flow.

As with the more common P/E measure, the lower the free cash flow multiple, the lower the valuation of the stock. That does not necessarily mean, however, that the lower-priced stocks always stand to appreciate more. If a company isn't growing, its multiple could remain very low. Even so, free cash flow is a great starting point in your evaluation.

Hidden Gems' focus on free cash flow
Tom Gardner's new Motley Fool Hidden Gems newsletter (consider a free trial) has a stern focus on finding two undervalued companies each month based on their free cash flow generation. Tom also has a more detailed way to find free cash flow that he teaches in the newsletter.

The Fool has a full disclosure policy -- to view a writer's holdings, check his or her profile.