👑 What you need to know about free cash flow
In the end, Free Cash Flow is all what matters.
But what is Free Cash Flow and how can you calculate it?
It’s one of the most important metrics in the world of finance.
I’ll teach you everything you need to know together with concrete examples.
What is Free Cash Flow?
In child language, Free Cash Flow is all the cash that enters a company minus all the cash that leaves a company over a certain period.
It shows you how much money a company generates after deducting all costs.
You can calculate it as follows:
Operating Cash flow = Operating Income + Non-Cash Changes - Changes in Working Capital - Taxes
CAPEX = Changed in Property, Plant & Equipment (PPE) + Depreciation
The Operating Cash Flow shows the amount of cash that is generated by a company’s normal business operations.
In other words, the Operating Cash Flow measures all the cash a company generates from selling its products and or services.
Example: When a clothing company called Jeans X generates $10 in cash per sold pair of trousers and they sell 2 million trousers per year, it’s Operating Cash Flow is equal to $20 million.
The Capital Expenditures (CAPEX) show how much money a company has used to maintain or buy physical assets.
Example: When Jeans X invests $5 million in its physical assets such as their factories, its CAPEX is equal to $5 million.
Now you know the Operating Cash Flow and CAPEX of Jeans X, you can calculate the company’s Free Cash Flow:
Free Cash Flow = Cash Flow from Operations - CAPEX
Free Cash Flow Jeans X = $20 million - $5 million = $15 million
You want the Free Cash Flow of a company to grow at very attractive rates.
Here’s an example of a company we own within the portfolio.
This company managed to grow its FCF with more than 10% per year over the past 20 years:
Why is Free Cash Flow important?
Free Cash Flow is important because it shows you whether more cash enters the company than leaves the company
This is useful for investors because you only want to invest in profitable businesses
You want to invest in companies that translate most Revenue and Earnings into Free Cash Flow
"Free cash flow is the ultimate measure of a company's strength and resilience." - Warren Buffett
What can a company do with its FCF?
In general, a company has 5 capital allocation options:
Reinvesting in itself for organic growth
Pay down debt
Acquisitions and takeovers (M&A)
Paying out dividends
Buying back shares
Capital allocation is by far the most important task of management.
You want to invest in companies that manage to allocate capital very efficiently.
In general, reinvesting Free Cash Flow to achieve organic growth is the most preferred capital allocation strategy.
Obviously, the company needs to have enough growth opportunities in order to do this.
It is also important to underline that it only makes sense to invest in organic growth when these organic investments create value (ROIC > WACC).
Free Cash Flow Margin
The best way to look at the profitability of a company, is by taking a look at the Free Cash Flow Margin.
This metric shows you how much cash a company is generating per dollar in sales.
FCF margin = (Free Cash Flow / Sales)
Visa for example has a Free Cash Flow Margin of 54.6%. This means that for every $100 in sales, Visa generates $54.6 in pure cash.
This in stark contrast with Delta Air Lines, which has a FCF margin of only 1.4%.
It goes without saying that it is justified to pay a higher valuation multiple for Visa compared to Delta Air Lines.
Here are 10 companies with a phenomenal Free Cash Flow Margin (> 30%) within the investable universe of Compounding Quality:
Free cash flow is NOT the same as Net Income
Earnings are an opinion, Cash Flow is a fact.
That’s why you should always look at the Free Cash Flow of a company and not at its Earnings.
While Earnings are an accounting metric, Free Cash Flow looks at the money that actually entered and left the firm over a certain period.
In other words: the Net Income of a company contains a lot of non-cash items whereas Free Cash Flow looks at the cash that effectively entered and exited the business.
Net Income = Total Revenue - Total Expenses
Free Cash Flow = Operating Cash Flow - CAPEX
To go from Net Income to Free Cash Flow, you should make the following adaptations:
Free Cash Flow = Net Income + Depreciation / Amortization - Change in Working Capital - Capital Expenditures
In general, Free Cash Flow can be seen as a better metric compared to the Earnings of a company because this metric is more reliable and harder to manipulate.
Free Cash Flow Conversion
Quality companies convert most Earnings into Free Cash Flow.
FCF Conversion = (Free Cash Flow / Net Earnings)
When there is a huge difference between the Free Cash flow and the Earnings of a company, you should be suspicious as an investor.
It gives an indication that the earnings quality of the company is low.
A study of James O’Shaugnessey (What Works on Wall Street) found that companies which translated most earnings into FCF outperformed companies that translated the least earnings into FCF by 5.3% (!) per year.
That’s why focusing on the FCF Conversion of a company can help you a lot to make better investment decisions.
Here are 10 companies within our investable universe which convert more than 100% of their Earnings into Free Cash Flow:
Become a Partner and get access to the investable universe as of the 1st of October:
Free Cash Flow Yield
The Free Cash Flow Yield (FCF Yield) of a company is a great way to look at the valuation of a company:
Free Cash Flow Yield = (Free Cash Flow Per Share / Stock Price)
The higher this ratio, the cheaper the stock.
You can compare the FCF Yield of a company with its historical average FCF Yield to get a first grasp about how expensive the company is an historic perspective.
Here’s the evolution of the FCF Yield of the first stock we’ll buy within the Compounding Quality Portfolio:
Watch out for Stock-Based Compensation (SBCs)
A lot of technology companies are giving a lot of Stock-Based Compensation (SBC) benefits to their employees to attract and retain talent.
For investors, SBCs are a cost as it dilutes existing shareholders.
“Stock-based compensation is a cost for investors and it should be treated like that. The name says it all: 'compensation’. If compensation isn't an expense, what is it?” - Warren Buffett
As a result, you should always look at the FCF per share excluding stock-based compensation to get a more reliable and conservative view of the company.
Free Cash Flow = Operating Cash Flow - CAPEX - Stock-Based Compensation
For example, Amazon has a FCF Yield of 1.9%.
However, when you would treat Stock-Based compensation as an expense (you should), the FCF Yield would decrease to 0.3%!
This is a huge difference and underlines why you should exclude Stock-Based Compensation.
Expected return
Last but not least, you can use the following rule of thumb to calculate your expected return as an investor:
Expected Return Per Year = FCF per share growth + Shareholder Yield +/- Multiple Expansion (Multiple Contraction)
Shareholder Yield = Dividend yield + Buyback yield
Let’s use Visa as an example.
We estimate that Visa will be able to grow its Free Cash Flow per share with 13% per year over the next 5 years
The Dividend Yield is equal to 0.7% and we estimate that the outstanding shares of Visa will remain constant in the near future
Furthermore, we think the current FCF Yield of Visa (3.6%) is fair, as a result no multiple expansion nor contraction will take place
Under these assumptions the expected yearly return for Visa is equal to:
Expected Return Per Year Visa = 13% + 0.7% + 0% = 13.7%
Would you be happy with an annual return of 13.7% per year? If so, Visa might be an interesting investment.
If you aren’t happy with this expected return, you should seek for other investment opportunities.
Overview
Here you can find a great overview about Free Cash Flow:
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