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.