Cash Flow Metrics: Part 1 – Introduction To Free Cash Flow
Peter Lynch, as well as several other very successful investors, made it a point to analyze cash flow and total cash. The reason being cash is much harder to manipulate than earnings making it a much better tool to evaluate companies with. After all, any company, if they try hard enough, can hide debt and make earnings seem much better than they really are, but cash is much more transparent… it’s either there or it isn’t.
Free cash flow is even harder to manipulate and is the core engine behind dividends, buybacks, and company reinvestment. FCF metrics are very important to have in your checklist, so keep reading to learn which ones should be included in your arsenal.
“Free cash flow is what’s left over after the normal capital spending is taken out.” -- Peter Lynch
What Is Free Cash Flow And Why Is It Important To Value Investors?
Cash in the bank is what every company, and investor, strives for. Companies with large amounts of cash have options to increase dividends, perform buybacks, or reinvest the capital back into their business. Cash flow is the amount of cash coming in minus the amount of cash going out of the company's bank.
Free cash flow (FCF) is a subset of cash flow and is the amount remaining after business expenses and capital expenditures have been paid, hence the term "free." In other words, this is the cash management can use to really create value for the company as well as shareholders. For simplicity sake let's use Apple as an example. We'll want to use at least a 5yr history for all out calculations to account for business cycles and to smooth out data.
- Free Cash Flow (FCF) - To calculate simply take operating cash flow and subtract out capital expenditures (CAPEX).
- 2015 FCF = 81,266 - 11,488 = $69,778
- 5yr Average = (69,778 + 49,900 + 44,590 + 41,454 + 30,077) / 5 = $47,160
- FCF Growth - Not only can we use FCF growth as an indicator of the company's real growth rate over the last 5 years, we can also determine the rate at which the company has grown organically. By analyzing FCF we exclude other factors and focus only on operating cash flow growth. Meaning we're concentrating on the firm's primary business rather than growth from issuing more shares or debt.
- ((2015 FCF / 2011 FCF) ^ (1 / 5) - 1) * 100
- ((69,778 / 30,077) ^ (1 / 5) - 1) * 100 = 18.33%
- A FCF growth of 18.33% is phenomenal, however keep in mind you're looking at the past with this number. It's not a guaranteed future growth rate, but it's still a nice number to start with.
Metrics To Use For Valuation Purposes
Now that you understand what FCF is and why it's useful, let's look at some ways to integrate this figure by using it in 3 different valuation metrics.
- FCF Yield - First up is FCF yield. This metric allows you to calculate the current valuation of a stock and compare it with other investments. In other words, it tells if a company is trading at a discount and how steep that discount is compared to other companies AND investments, such as bonds. I have a detailed article on this metric here.
- FCF Yield = (TTM FCF / Enterprise Value (Market Cap + Long-Term Debt - Total Cash)) * 100
- (55,175 / (536,200 + 69,374 - 55,283)) * 100 = 10.03%
- FCF yield of 10.3% is not bad at all. Usually anything above 10% is something to look into, especially when T-bills and other investments such as CDs are earning around 2-3% right now.
- FCF / Sales - This is a ratio that tells you what percentage of sales is transformed directly to FCF. While we definitely care about growth and yield, the FCF to sales metric shows profitability combined with business operations.
- (FCF / Revenues) * 100
- (55,175 / 227,535) * 100 = 24.25%
- 24.25% is fantastic. Typically any number above 15-20% means the company is a cash-cow that has a significant competitive advantage.
- EV / FCF - Simply the inverse of FCF yield. You can use this metric in place of P/E or EV/EBITDA and I wouldn't blame you since using FCF is always preferable, in my opinion, to earnings.
- Enterprise Value / FCF
- (536,200 + 69,374 - 55,283) / 55,175 = 9.97
- Anything under 15 (historical P/E average) would be considered undervalued however, an EV/FCF below 10 could be a bargain. Historically, the great Warren Buffett has invested in companies trading at these levels.
In the end, FCF metrics are very beneficial. You can use them to verify earnings, determine a realistic growth rate, and even as valuation techniques. As we continue this series we'll dive deeper into all the different ways you can use cash flow numbers. Stay tuned for part two where we'll discuss cash generating power (excitingly named) as well as several others.