Free Cash Flow – Beginning Value Investor Terms
Posted on | November 18, 2009 | No Comments
This is the latest in my on going series of Beginning Value Investor Terms. Free Cash Flow (FCF) is a similar concept to Warren Buffett’s idea of “owner earnings.” It is an important concept in value investing largely because it is often a preferred bit of a financial data to Earnings. The reason for this is simple: Free Cash Flow at its core is the cash that a company is left with after accounting for Capital Expenditures (Capex) and changes in working capital and adding back in Depreciation and Amortization. So the formula for your speadsheet is FCF= Earnings+Depreciation+Amortization-Changes in Working Capital- Capex. OR there is a simpler way of calculating it FCF = Cash Flow from Operations- Capex. In other words Free Cash Flow is what a company really has left over at the end of the year. It is the amount that you can turnover to investors in dividends, buy back stock, pay down debt or just let sit on your balance sheet.
The justification for this additional calculation is sometimes that earnings can be manipulated by companies but cash flows are harder to manipulate. That makes sense except that the first item in the FCF calculation is Earnings. So, if a company has manipulated earnings using Free Cash Flow may or may not correct the problem. More importantly though FCF tells you where a company is right now. It gives you an idea of how profitable a company is factoring in variety of future expenses that are accounted for in Depreciation and amortization costs and current costs to keep a company running such as capex that are independent of the cost of goods sold (COGS).
This or my version of “Owners Earnings” is one of the metrics I use for evaluating a company long term. I evaluate the growth of FCF over ten years, if possible. If you do and you add in an ample margin of safety, you will find much fewer real opportunities than those investors who rely on Earnings.
A word of caution. For Companies that are in the process of building manufacturing capacity, or are in a grow phase where capex requirements are higher, FCF may give a distorted (to the low side) idea of future valuation. Like any valuation metric, You must use FCF of many factors when you are deciding to buy or not to buy a company.
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Tags: Beginning Investor > Investing 101
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