“Free Cash Flow is the cash remaining after making investments in capital assets.”
Free cash flow (FCF) measures a company’s financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from its operating cash flow.
FCF measures a company’s ability to produce what investors care most about: cash that’s available to be distributed in a discretionary way. The ways a business can use their free cash flow include:
- Pay dividends
- Buy back shares
- Make an acquisition
- Pay down debt
Free cash flow (FCF) is the cash that remains after a company pays to support its operations and makes any capital expenditures (purchases of physical assets such as property and equipment.
Free cash flow is related to, but not the same as, net income. Net income is commonly used to measure a company’s profitability, while free cash flow provides better insight into both a company’s business model and the organization’s financial health.
Many analysts believe that FCF is one of the key financial indicators for measuring business performance over the long term and provides useful information regarding how cash provided by operating activities compares to the property and equipment investments required to maintain and grow the business.
In addition to other financial measures, free cash flow (FCF) can be used to manage a business, make planning decisions, evaluate performance, and allocate resources.
There are two definitions of free cash flow:
- Free cash flow to equity (FCFE) is the cash flow available for distribution to a company’s equity-holders. It equals free cash flow to firm minus after-tax interest expense plus net increase in debt.
- Free cash flow to firm (FCFF) (also referred to as free cash flow) of a company is the cash flow in an accounting period which is available for distribution to the company’s debt-holders and equity-holders.
FCFE differs from FCFF in that the free cash flow to firm is the cash flow that is available for distribution to both the debt-holders and equity-holders while the free cash flow to equity is the cash flow that’s available only for distribution to equity-holders.
Free cash flow to firm (FCFF) valuation model is appropriate when the company do not pay dividends or where the dividends are disproportionate to the company’s earnings.
Free cash flow enables management to decide on future ventures that could improve the shareholder value. Additionally, having an abundant FCF indicates that a company is capable of paying its monthly dues. Companies can also use their FCF to expand business operations or pursue other short-term investments.
When compared to earnings, free cash flow is more transparent in showing the company’s potential to produce cash and profits. FCF serves as an important basis for determining the intrinsic value of a company and pricing its stock.
The formula below is the most commonly used formula for levered free cash flow:
Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures
Most information needed to compute a company’s FCF is on the cash flow statement.
As an example, let Company A have $22 million dollars of cash from its business operations and $6.5 million dollars used for capital expenditures, net of changes in working capital. Company A’s FCF is then computed as:
FCF = $22 – $6.5 = $15.5m
DCF Analysis and Stock Valuation
Stock valuation is the process of determining the intrinsic value of a share of common stock of a company. The purpose of stock valuation is to find the value of a common share which is justified by the company earnings and growth potential, identify undervalued and overvalued stocks, overweight or underweight them in an investment portfolio and generate alpha i.e. excess return.
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the business’ unlevered free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Capital (WACC).
The weighted average cost of capital (WACC) is the minimum return a company must earn on its projects. It is calculated by weighing the cost of equity and the after-tax cost of debt by their relative weights in the capital structure.
WACC is an important input in capital budgeting and business valuation. It is the discount rate used to find out the present value of cash flows in the net present value technique.
The absolute valuation approach attempts to find intrinsic value of a stock by discounting future cash flows at an discount rate which reflects the risk inherent in the stock.
Free Cash Flow Models
The free cash flow valuation models can be used to value a majority i.e. controlling ownership based on free cash flows of the company which equals the cash flows from operating activities less any expected changes in working capital less any expected capital expenditure.
The single-stage free cash flow model discounts the expected free cash flows at the end of Year 1 at the weighted average cost of capital.
Stock Value = FCF1 / (WACC − g)
Where FCF1 is the free cash flow at the end of Year 1, WACC is the weighted average cost of capital and g is the growth rate of free cash flows.
Another back of the envelop valuation method is to take product of the five year average of free cash flow and multiply by twenty. Compare the product to the company’s market cap for a quick valuation model.
A business ability to generate significant amounts of free cash flow for years, which will support debt repayments, dividend payouts, share buybacks, and acquisition, is an essential valuation metric. Free cash flow can demonstrate a company’s ability to reward investors. It can provide useful information to help investors better understand underlying trends in a business.
Free cash flow is not perfect and has limitations, but it is more difficult to manipulate than net income or earnings per share.
FCF has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of other financial measures, such as return on invested capital (ROIC) and earnings. One of the limitations of FCF is that it does not reflect future contractual commitments.
FCF, as compared with net income, gives a more accurate picture of a firm’s financial health and is more difficult for a company to manipulate, but it isn’t perfect. Because it measures cash remaining at the end of a stated period, it can be a much “lumpier” metric than net income.
For example, if a company purchases new property, FCF could be negative while net income remains positive. Likewise, FCF can remain positive while net income is far less or even negative. If a company receives a large one-time payment for services rendered, its FCF very likely may remain positive even if it incurs high amortization expenses (like the costs of software and other intangible assets for a cloud computing company).
In a nutshell, 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.
References:
- https://corporatefinanceinstitute.com/resources/knowledge/valuation/what-is-free-cash-flow-fcf/
- https://xplaind.com/121791/free-cash-flow-to-equity-fcfe
- https://xplaind.com/408436/free-cash-flow-to-firm-fcff
- https://corporatefinanceinstitute.com/resources/knowledge/valuation/valuation-methods/
- https://xplaind.com/965210/cost-of-capital
- https://www.fool.com/investing/how-to-invest/stocks/free-cash-flow/
- https://www.fool.com/investing/general/2007/09/05/foolish-fundamentals-free-cash-flow.aspx