Free cash flow is defined as the remaining cash flows that is available for use by the company to bring additional wealth and value to the shareholders after all the bills have been paid, which are directly related to operations. Obviously this is a very important item for any investors and analysts to look at because the primary objective of any business is to generate cash flows for the owners. This is essentially measuring whether or not a business is capable of doing its job. Free cash flows is one of the most common metrics used to analyze the value of a stock.
The problem that one can run into is trying to calculate actual free cash flow. The reason for this is that multiple valuation methods exist where the calculated free cash flows of a company can come out differently, even by using the same exact numbers and financial statements. This can be attributed to the fact that free cash flows are not a financial measure that is regulated or required by GAAP (generally accepted accounting principles), even though a company must file a statement of cash flows on a quarterly basis. Therefore, there is no set definition used for free cash flow.
Just for an example, let us take a look at the most basic formula for free cash flows. This is the one I use in most cases:
Free Cash Flow = Operating Cash Flow - Capital Expenditures
As you can see, this is basically a simple idea of stating that free cash flows are just what is left over after you pay the costs of operations as well as the cost to expand or maintain those operations. However, more recently the ideas of calculating free cash flows in other ways have been developed as well.
This method is as follows:
Free Cash Flow = Net Operating Profit After Taxes – Investment (all during the same time period)
This can be more difficult to grasp conceptually as the method of calculation involving NOPAT includes more calculations as well as more opportunities for a company to suggest what it is. In the very simplest of formats, no pat is what a company would earn if it didn’t have debt. This is already a difficult concept to act upon because the truth is the company can’t assume that it doesn’t have debt if it actually does. NOPAT is more similar to EBITDA, which is a “controversial” method used by some value investors, but strongly criticized by others like Warren Buffett. It’s sort of a “best case” scenario and acting upon that is quite difficult to do in confidence.
Some other methods that have sprung up recently would include calculating Free Cash Flows to the Firm (FCFF) and Free Cash Flows to the Equity (FCFE). These have become more popular with investment bankers, and the formulas that bind them together are:
FCFF = Operating Income (after tax) + Noncash Charges – Capital Expenditures – Working Capital Expenditures
FCFE = Net Income + Noncash Charges – Capital Expenditures – Working Capital Expenditures
FCFE = FCFF + Net Borrowing – Net Debt Repayment
Obviously, the methods of valuations can differ depending on the specific way that items are regarded within the calculations themselves.
If done correctly, the free cash flows of any company will only be able to be used as a guide of what the company has in potential. It will not show that they are going to make good decisions using that cash in the future; however, it will show how they are able to generate additional cash after they pay their expenses. This additional cash can be used for the purpose of continuing to expand their operations, mergers and acquisitions, or to buy back shares of stock. Additionally it can be used for dividends to pay back the owners of the company.
When someone tells you FCF of a company ask right away, which method they are using. The numbers can differ drastically based on the methodology. In part II of this article I am going to take a company using the various methods of FCF described above and show how the numbers for FCF can differ drastically based on the method used.
http://www.valuewalk.com
The problem that one can run into is trying to calculate actual free cash flow. The reason for this is that multiple valuation methods exist where the calculated free cash flows of a company can come out differently, even by using the same exact numbers and financial statements. This can be attributed to the fact that free cash flows are not a financial measure that is regulated or required by GAAP (generally accepted accounting principles), even though a company must file a statement of cash flows on a quarterly basis. Therefore, there is no set definition used for free cash flow.
Just for an example, let us take a look at the most basic formula for free cash flows. This is the one I use in most cases:
Free Cash Flow = Operating Cash Flow - Capital Expenditures
As you can see, this is basically a simple idea of stating that free cash flows are just what is left over after you pay the costs of operations as well as the cost to expand or maintain those operations. However, more recently the ideas of calculating free cash flows in other ways have been developed as well.
This method is as follows:
Free Cash Flow = Net Operating Profit After Taxes – Investment (all during the same time period)
This can be more difficult to grasp conceptually as the method of calculation involving NOPAT includes more calculations as well as more opportunities for a company to suggest what it is. In the very simplest of formats, no pat is what a company would earn if it didn’t have debt. This is already a difficult concept to act upon because the truth is the company can’t assume that it doesn’t have debt if it actually does. NOPAT is more similar to EBITDA, which is a “controversial” method used by some value investors, but strongly criticized by others like Warren Buffett. It’s sort of a “best case” scenario and acting upon that is quite difficult to do in confidence.
Some other methods that have sprung up recently would include calculating Free Cash Flows to the Firm (FCFF) and Free Cash Flows to the Equity (FCFE). These have become more popular with investment bankers, and the formulas that bind them together are:
FCFF = Operating Income (after tax) + Noncash Charges – Capital Expenditures – Working Capital Expenditures
FCFE = Net Income + Noncash Charges – Capital Expenditures – Working Capital Expenditures
FCFE = FCFF + Net Borrowing – Net Debt Repayment
Obviously, the methods of valuations can differ depending on the specific way that items are regarded within the calculations themselves.
If done correctly, the free cash flows of any company will only be able to be used as a guide of what the company has in potential. It will not show that they are going to make good decisions using that cash in the future; however, it will show how they are able to generate additional cash after they pay their expenses. This additional cash can be used for the purpose of continuing to expand their operations, mergers and acquisitions, or to buy back shares of stock. Additionally it can be used for dividends to pay back the owners of the company.
When someone tells you FCF of a company ask right away, which method they are using. The numbers can differ drastically based on the methodology. In part II of this article I am going to take a company using the various methods of FCF described above and show how the numbers for FCF can differ drastically based on the method used.
http://www.valuewalk.com
