Thursday, January 24, 2013

Free Cash Flow

Free cash flow (FCF) is calculated by subtracting Capital expenditures from Operating cash flow. Cash Flow from Operations measures how much cash a company generates. It is the true touchstone of corporate value creation because it shows how much cash a company is generating from year to year. As useful as the Cash Flow statement is, it does not take into account the money that a firm has to spend on maintaining and expanding its business. To do this, we need to subtract Capital Expenditures, which is money used to buy fixed assets.

Free Cash Flow =Cash Flow from Operations - Capital Expenditure

Free Cash Flow enables us to separate out businesses that are net users of Capital - ones that spend more than they take in- from businesses that are net producers of Capital, because its only that excess cash that really belongs to shareholders.

Free Cash Flow is sometimes referred to as "Owners Earnings" because that's exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company's ongoing business.

A firm that generates a great deal of FCF can do all sorts of things with the money - save it for future investment opportunities, use it for acquisitions, buy back shares, and so forth. Positive FCF gives financial flexibility because the firm isn't relying on the capital markets to fund its expansion. Firms that have negative FCF have to take out loans or sell additional shares to keep things going, and can thus become a risky proposition if the market becomes unsettled at a critical time for for the company.

There is a view that most analysts myopically focus on earnings while ignoring the real cash that a firm generates. While earnings can often be clouded by accounting tricks, it's much tougher to fake cash flow. For this reason, seasoned investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits).

Rough benchmarks for analysing a firm's Free Cash Flow

As with ROE it’s tough to generalise how much FCF is enough. However its reasonable to say that any firm that is able to convert more than 10% of Sales to FCF (just divide FCF by Sales to get this percentage) is doing a solid job at generating excess Cash.

Using Free Cash Flow ratio while analysing stocks

I tend to think positive FCF companies will always have low levels of business risk than those with negative FCF. It's also extremely useful to draw a direct correlation between FCF and RoE.
I like to see companies with high FCF coupled with high RoEs, this is the sweet spot - excess cash and the ability to earn a high return on it. Companies with these characteristics tend to be the cream of the crop and have a low level of business risk. 

Negative FCF is not necessarily a bad thing. Because, you can always find companies that are re-investing all of their cash in business expansion but are still able to generate a high RoE. These firms have profitable reinvestment opportunities, and they should be spending all the cash they generate on expansion. These expansion efforts may pay off in the form of fat profits in the future. 
Apart from identifying the "cream" to form the Core of my portfolio, and separating excellent businesses from the rest, I have learnt not to give too much importance to FCF while stockpicking - especially multibagger prospects, except to check that the trend is improving. For these kind of companies in their early growth stages with nice RoE levels, I rather check that Operating Cash Flow should be positive and increasing. If Operating Cash Flow is negative and/or shows a declining trend over a number of years, that's a red herring (warning sign) for me, leading me to pass up on them.