What is Free Cash Flow?

Free Cash Flow or FCF refers to the cash available for a company to pay dividends and interest to investors or repay creditors. In other words, it measures a company’s financial performance by calculating the cash a company can produce after purchasing assets such as equipment, property, or other major investments. It calculates the distributable cash available.

Because FCF is a reflection of the cash flow available for repaying creditors or paying dividends by companies, many investors prefer it over earnings per share as a measure of profitability. However, the FCF can get lumpy and uneven over time as it also accounts for investments in plant, equipment, and property. 

The FCF can provide important insights into the value of a company as well as the health of its fundamental trends, as it accounts for changes in working capital. For instance, a decrease in accounts receivable may indicate that the company is collecting cash from its customers faster. 

There are two common types of FCFs available

  • Unlevered FCF or Free Cash Flow to the Firm(FCFF)
  • Levered FCF or Free Cash Flow to Equity

Example of FCF

Real Stock FCF Example

To understand how FCF works, let us consider the following example: 

Real Stock FCF ExampleInvestors can be absolutely certain that there are some issues present within the companies. However, these issues aren’t apparent in the above “headline” numbers such as earnings per share and revenue.  The issues can be caused by a number of factors such as the following: 

  • Investing in growth: Sometimes when the management of a company is investing heavily in property, plant, and equipment for business expansion, it can produce diverging trends such as the above. Investors can confirm this by looking at the Capital expenditure or CAPEX of the company for the period 2016 to 2018. If both of them are still upwardly trending, it’s a positive scenario. 
  • Credit Problems: A Company’s inventory fluctuations or shift in accounts payable and receivable can cause a change in working capital. When a company’s sales struggle, accounts receivable will increase if the company extends more generous payment terms to their clients. This may account for a negative adjustment to the FCF. Another negative adjustment to the FCF includes a reduced account payable which usually occurs when a company’s suppliers require faster payment. 
  • Stockpiling inventory: It may so happen that a company’s inventory grows by a larger percentage compared to its sales. This can cause the FCF to fall even though revenues increase. 

A simple way to value a stock with Free Cash Flow

Investors can determine the value of a firm by finding out the present value of its operating free cash flows along with several other aspects. 

  • Operating Free Cash Flow: The Operating Free Cash Flow includes equity as well as debt providers.  The formula is as follows: 

Operating Free Cash FlowThe free cash flow to the firm provides an accurate reflection of the overall cash-generating capabilities of the firm. 

  • Growth Rate Calculation:: The growth rate has a drastic effect on the resulting value of a firm and can be very difficult to predict. One of the ways one can calculate is by multiplying the ROIC or return on the invested capital by retention rate.  The retention rate refers to the percentage of earnings the company holds which is not paid out as dividends. The formula is as follows: 

Growth Rate Calculation

  • Valuation: The method of valuation is based on operating cash flows received after deducting capital expenditures, which reflect the cost of asset base maintenance. Here, the cash flow is taken before interest payments to debt holders. A discount rate is required for discounting any stream of cash flows, which in this case, is the WACC or Weighted Average Cost of Capital. We then discount the resulting Operating Free Cash Flow or OFCF at this cost of capital rate, using three possible growth scenarios.
    • Constant Growth: Calculating a constant growth rate is more suitable for a mature company.

Valuation

    • No growth: By discounting the OFCF by the WACC, we can find the value of the firm. The calculation is as follows: 

No growth

    • This model is applicable for firms expecting more than one growth stage. The analyst needs to predict higher than normal growth, as well as the expected duration of it. The firm goes back to normal steady growth after this high growth.
      For example, we assume that a firm has $200 million worth operating free cash flows. It is expected to grow at a rate of 12% for 4 years. However, it will return to a normal growth rate of 5% after 4 years. 

Free Cash Flow

In the above example, the OFCF was 12% for the first four years, reverting back to 5% from the fifth year on. It is currently $5.35 billion dollars after decreasing back to the present value.