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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 an idea of 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 all its employees' salaries, its bills, its interest on debt, and its 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 files 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 2006 |
FY 2005 |
FY 2004 |
|---|---|---|---|
|
Cash flow from operations |
$525,300 |
$627,200 |
$1,086,800 |
|
- Capital expenditures |
($962,900) |
($760,000) |
($703,600) |
|
= Free cash flow |
($437,600) |
($132,800) |
$383,200 |
In its most basic form -- and sometimes that 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 whether it exists 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 by looking 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 in 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.
