Free cash flow, a dreadfully simple term to calculate, is one of the most important tools in identifying Rule Makers. This is because a Rule Maker is, by definition, a company that has a Cash King Margin of 10% or more. The numerator for the Cash King is none other than free cash flow (the denominator being sales), so only companies that have truly outstanding free cash flow numbers are going to meet this crucial test. Well, you could have a company with miserable sales, but in such a case the company would be failing, oh, eight or nine of the other criteria.

But what is free cash flow? Well, it's "free cash," but it's more important than that. Free cash flow, in the rawest sense, is the basis for why a company exists in the first place. And if this is the case, when you invest, you are buying the right to a proportional amount of the future cash flows of the company. Note that doesn't say "earnings," it says cash flows -- what's left after the company has paid for everything else, from the salary of the CEO to the parsley garnish on platters at company events. Free cash, in effect, is the money that the company could send its shareholders in dividends on an annual basis.

So, it's really important to know what free cash flow is, and how you calculate it. It's also important to know when you should temper your dependence upon free cash flow, which I'll explain in a minute.

Free cash flow is the amount of money that the company has left over after you take all of its operational earnings and subtract out all capital expenditures. The best way to demonstrate this is to look at the cash flow statement from one of our Rule Maker Companies, Coca-Cola (NYSE: KO): 

Coca-Cola           Fiscal Year ended Dec. 31,
(in $ millions)     1999    1998    1997   1996
Net Cash
Provided by
Operating 
Activities     (A)  3,833  3,433   4,033  3,463

Purchases of
Property, Plant,
and Equipment  (B) (1,069)  (863) (1,093)  (990)

Both of these numbers are listed on the cash flow statement. There's no massaging to be done, no reading between the lines, just take the numbers. You can do this for any company. To calculate free cash flow, just add A and B. If you remember seventh-grade math, you'll certainly recall that when you add a negative number, you actually subtract. Same thing goes here, a positive number is an addition of cash, a negative is a subtraction of cash. 

Free Cash Flow (A+B) 2,764  2,570  2,940  2,473

So Coca-Cola has, in its operations, produced in excess of $10.7 billion in free cash over the last four years, though it has produced less in each of the last two years than it did in 1997. Again, this free cash flow is the amount of money that was left over, that the company could do with whatever it felt best to do, be it issue dividends (Coke's total dividend payment over the last four years was $5.7 billion dollars), repurchase shares (Coke repurchased $4.3 billion of its own shares during the same period), or just invest it.

But at any rate, in the basest sense, this free cash is what you are buying the rights to when you invest in any company. The share price of any stock, be it Coke or another Rule Maker, an unprofitable Internet stock, or even a crummy little penny stock, is based upon the current value of all future cash flows from the company. This, by the way, is one of the reasons that rising interest rates are supposed to temper the prices of stocks, because the level of discounting for all future cash flows is tied to the prime lending rate. As the rate goes up, the discount percentage does as well, and it lowers the implied present value of all those future earnings.

Well, it's supposed to, at least. More to the point is that we have no way of predicting the future movement of interest rates, so the value we give to those earnings is deeply colored by a factor that is both fluid and fairly unpredictable.

The other reason we love free cash flow is that it is very difficult for companies to gloss it the way they can earnings. Companies can push expenses around, can focus on EBIT, EBITA, EBITDA, or other factors to make earnings look better. They can even try to treat some operational expenses as capital expenditures -- whatever. But the full, unvarnished truth will show up in free cash flow. It is the very first thing I look at when I get financials from any company.

A word of warning about free cash flows, though. There is a very valid forward-looking approach by investors to try to find smaller market cap companies that have promising prospects. Often, these companies are in development stage and have capital expenditures (those expenses listed under Property, Plant, and Equipment) that far outweigh their current earnings. As such, these companies, being investment-stage operations, should not be quite so closely tied to their free cash flow returns. In such a case, I would look for a positive trend in free cash, but also look to other metrics such as gross profit growth and topline revenue growth commensurate with capital expenditures.

I have to admit, I love this time of year, when every day seems to bring me a new annual report -- the sometimes glossy, almost always self-complimentary rendering of a company's 10-K. By the time the annual report arrives, I've already gone through the numbers, made available electronically, usually on the company's website, but always on FreeEDGAR or Fool Quotes/Data. There really is not that much additional information in the annual report, but I like the affirmation that I am a business owner, that I have purchased a part of a company, and am receiving an operational report.

The vast majority of companies have their fiscal years run coincidentally with the calendar year, so their fourth quarter ends on December 31 -- hence, the reason that investors receive the highest number of annual reports right about now, with annual shareholder meetings soon to follow. If you've never been to an annual meeting, I highly recommend it. You may get a deeper insight into your company.

To close, a homework assignment. Break out all those glossy reports you've been receiving, fire up the calculator, and do some Cash King Margin calculations. I've showed you how; it's not that hard. You may be holding a company that we here at Fooldom are unaware of that would make a great Rule Maker. Excellent free cash flow is a great first step. Feel free to let us know about it on the Rule Maker Companies discussion board.

Fiat Fool!

Bill Mann, TMFOtter on the Fool boards.