What is Free Cash Flow?

Free Cash Flow = Operating Cash Flow – Investment Costs

Where… Operating Cash Flow is the cash surplus generated by the business.

Investment Costs include, for example, purchases of tools and machines

Therefore… Free cash flow is the amount of money remaining after deducting a company’s capital costs from its operating cash flow.

Thus, free cash flow demonstrates that the company can distribute money to its shareholders if it would prefer that to investing in the business.

When and Why is Free Cash Flow Used as a Valuation Measure?

Primarily, it is used to determine how much money stays within the company. A company may report low profits or even losses, but in reality, they may have earned a lot of money, simply reinvesting these funds within the business (i.e., purchasing new assets or securities with the money).

This is common in Growth companies. Therefore, they rarely show a positive cash flow.

Through cash flow analysis, you can see where and how the money is used.

How Does Free Cash Flow Differ from “Regular” Cash Flow?

It depends on the context. Operating cash flow shows the surplus from operations. Free cash flow is the surplus after investment activities and capital costs. When people use the term “profit” without specifying, they often refer to the overall operation’s profitability over the long term, whether the company collects its cash in advance or must wait longer before receiving payment for invoices. This relates to the cash conversion cycle.

How Can Cash Flow Analysis Help Identify Investments?

It depends on the type of company you are examining.

But it is particularly important to check the cash flow for Growth companies. If they increase revenue without increasing their cash flow potential, it’s usually a warning sign. It means they can have scaling problems.

Here are two good examples of companies where cash flow was the right thing to look at:

Case studies

TCI – Tele-Communications Inc.

TCI was a company laying TV cables in the USA. They incurred a huge investment cost to get the government license and lay the cable. This was capital-intensive, so they needed to borrow a lot of money to afford it. But then followed stable revenues for many years, and they could calculate it with quite high accuracy. What does free cash flow have to do with this? Well, this: TCI created a lot of cash flow, but they always reinvested the cash, and borrowed even more, to lay even more cables. So if you only looked at their cash flow, they seemed worthless. However, a cash flow analysis showed that they “could” have produced a positive cash flow if they wanted to. And eventually, they chose to do so. TCI has been one of the best stocks in the last 40 years. They had an average annual growth rate of 30.3%. If you invested $1 from the beginning in 1973, it would have become $900 by 1999 (when the company was sold to AT&T).

Bloomberg:

Bloomberg has been — and still is — one of the world’s best companies. (Unfortunately, it’s private). Why is it so good? Because it has tremendously positive cash flows, in a very predictable way. How? By selling one of the world’s most expensive subscription services, with a low rate of users terminating their subscriptions (“churn”). This makes their business both profitable, highly cash generative and very predictable. It’s a significant advantage if cash flows are predictable because then the company can plan ahead. It makes it easier to run the company, budgeting etc.

Compare Bloomberg with a small toy manufacturer/or children’s app developer, which must create new toys or apps to satisfy children every year (or maybe month), by stimulating their dopamine levels. Every toy/game this company creates is an unpredictable experiment (due to unpredictable consumer preferences). Perhaps these companies occasionally get a winner here and there (like Candy Crush, which pays for all the company’s failed experiments), but the rest of the games fail. In other words: These companies typically don’t generate positive cash flows every year. More cash is paid out than collected.

Valuation and cash flow

When is a company worth a higher cash flow multiple?

It depends on whether the company is in a capital intensive industry or not. A company in a capital intensive industry requires a much higher initial cost, and therefore needs more predictable future income. If they are in an industry where there are high initial investment costs, then as an investor, you need to get much more out afterward. The difficulty is in predicting the future.

Here TCI is a good case study.

A company in a capital intensive industry needs a clear reason for how they can beat their adversaries (top 2 competitors). A company in a capital intensive industry needs more capital than its peers.

In which companies is cash flow particularly interesting, and which is irrelevant?

Particularly interesting: Distressed debt — companies with a promising future but not earning money at present and need temporary support from investors to continue operating. Also Real Estate, Investment Companies with large debts.

Normally: A mediocre but profitable company.

Which famous investors use free cash flow?

A lot. But it’s something that value investors use especially. For example:

Warren Buffett – who even invented his own measure, “Owner Earnings”

Chris Lightbown – in his investment in Andina (Coca-Cola’s distributor in Chile)

Bill Ackman – Wendy’s

All real estate investors

Value = cash flow (the sum of all future “profits”)

Sum of Cash Flow equal Value, not the stock price

It bears repeating that the actual value of a company is its cash flows, not its stock price. I, however, use profits, earnings, sales, value and cash flows as proxies for the same thing: the value created.

I often simply talk about ‘sales’ when I mean the entire value creation process chain, which includes unit price, volume, sales, profits, investments, cash flows, and the sum of cash flows, which ultimately equate to the total value created.

Sales at a certain profit margin translate to profits that are reflected at different levels of the Income Statement, such as EBIT (Earnings Before Interest and Taxes), EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), PBT (Profit Before Taxes) or net earnings. And Earnings translates to various measures of normalized annual cash flows via depreciation and investment requirements.

A company must eventually have positive cash flow, or issue new shares or take on debt.

An otherwise good company with high cash generation potential, with temporary debt issues, may be a good acquisition candidate.

Some companies can avoid taxation by investing heavily and writing those investments off during the following few years.

You May Also Want to Read:

• Investing Styles: Bill Ackman
• More Information Regarding Cash Flows
• How to Think About Growth-Stocks