Free cash flow (FCF) can play an important factor in the stock analysis of many investors. It essentially represents how much cash a company gets to keep at the end of the day. Some investors actually prefer to use FCF in their stock analysis over the earnings of the business. This is because as business owners, what actually matters the most is how much money we are able to keep in our pockets at the end after paying all expenses.
How to Calculate Free Cash Flow
The free cash flow can be calculated by the numbers from the cash flow statement of the company. Usually, FCF isn’t directly given by a company, however, some financial sites may already calculate and provide this number at the financial section of each business for the investor.
The formula for free cash flow is as follows: Operating Cashflow – Capital Expenditures = FCF
The operating cash flow of a business is also oftentimes referred to as “cash flow from operations” or “net cash from operating activities”.
Capital Expenditures or CAPEX is defined as the amount of money that is required to acquire, maintain, or improve fixed assets of the business such as buildings, property, equipment, and technology. Both operating cash flow and CapEx can be directly located on the cash flow statement of a company.
Why Is Free Cash Flow so Important?
As stockholders, investors either make money by receiving dividends from the business or capital appreciation, which is the price increase of shares. Free cash flow for equity is the amount of cash that is left to the shareholders after paying all capital expenditures to maintain the operating business.
A business can either use the free cash flow to pay out any dividends to its shareholders, fund stock buybacks to increase the value of each share, or reinvest the money back into the business. The amount of free cash flow is essential as it represents how the company is capable to execute these actions that ultimately bring a profit to the investor.
And because FCF is such a raw number and has a direct impact on the company, many investors prefer to rather look into the free cash flow number of a business than to purely rely on the earnings.
For instance, if we have the company XYZ and company ABC both have $1,000,000 in operating cash flow. How would an investor be able to differentiate the qualities of both companies? By looking into the FCF of each company, we would obtain a much better outlook of how well each business truly operates and how its financial health is doing.
Let’s further assume that company XYZ has $400,000 in capital expenditure, while company ABC only has $100,000. If we then subtract these two numbers with each’s operating cash flow, we arrive at a FCF of $600,000 for company XYZ and on the other hand a much greater free cash flow of $900,000 for the company ABC. The result concludes that company ABC is more efficiently producing cash for the business and its owners than company XYZ.
What Is Free Cash Flow Used For?
As already mentioned briefly above, the free cash flow can be spent on different business activities. It is up to the board of directors which method is best for the business and for its owners. FCF indicates how much cash a company has at the end to fund different activities:
- Stock Buybacks. A company can buy back its shares from the market to decrease the number of shares outstanding. This leads to an increase in price for each share. Generally, this turns out positive for the investor but it should also be made clear why the business undertakes a share buyback.
- Dividend Payments. Dividends are most of the time cash payouts from the company to its shareholders as a reward for being an owner of the business. This action is also appreciated by most investors, however, note that each dollar that is being paid out as a dividend is also a dollar, which can’t be reinvested to enhance further growth of the company.
- Reinvestments into the business. Cash is what’s required for a company to expand its business, develop new products or pay down debt. A company essentially needs cash to funds its growth in the future.
How to Analyze Free Cash Flow
Free cash flow might be a much more crucial number for investors to look at rather than revenue or net income. But how exactly should free cash flow be analyzed?
Just like revenue and net income, a history of consistently growing free cash flow can be a very positive indicator of financial health and great future prospects for the investor. However, the comparison between free cash flow and the current share price of a stock should also be taken into consideration. A low price to FCF ratio may signalize that a company is fairly priced and investors may profit, as chances are that the share price is going to rise along with the growth of FCF.
While the price-to-earnings ratio is arguably the most widely used metric in stock analysis, free cash flow can sometimes offer a much deeper and more comprehensive insight into the underlying financials of the business.
A company, for instance, might be considered as greatly valued from the perception of the price-to-earnings ratio, but at the bottom line, it may have very poor free cash flow, which is essentially more important to the company and investor. A low P/E ratio doesn’t have to always come along with a low P/FCF ratio.
The relationship between the price and FCF should also be compared amongst companies that are operating within the same industry. Levels of P/FCF will differ from one industry to another.
There is a reason why investors might prefer to analyze free cash flow over earnings or revenue. Free cash flow shows how efficient a business is at producing cash. Positive free cash flow indicates that a company can fund its operations and still has cash left over for dividend payments, share buybacks, or further expansion. If not already stated, free cash flow can simply be calculated with the operating cash flow and CAPEX, which are both given in the cash flow statement of a company.