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Free Cash Flow: What is it and Why is it Important?

The cash flow statement is probably the most useful tool for judging or testing a company's liquidity position.

In the statement are many ratios and parameters that help in testing a company's financial health.

And one such parameter is the free cash flow earned by the company.

Free Cash Flow (FCF) is the cash earned by the company that can be actually distributed to the shareholders.

Investors love companies that produce plenty of free cash flows. It signals a company's ability to repay debt, pay dividends, buy back stock, and facilitate the growth of business - all important undertakings from an investor's point of view.

Investors take into consideration valuation parameters like price to earnings (P/E) and price to book value (P/BV).

While both these valuation parameters reflect the present earning capabilities, they do not signal the 'future' prospects.

And that's where Free Cash Flow comes into picture.

FCF considers not only the earnings of the company but also the past (depreciation) and present capital expenditures, capital inflows and investment in working capital.

Let us understand this by looking into what goes behind calculating Free Cash Flow of a company.

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How to Calculate Free Cash Flow?

The formula for calculating Free Cash Flow is as:

Net Profit + Depreciation - Capital expenditure - Changes in Working Capital - Dividend

Growing free cash flows are frequently a prelude to increased earnings.

Companies that experience surging FCF due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distribution (from subsidiaries) or debt elimination can reward investors in the future.

Better free cash flows are therefore a reason for the investment community to cherish.

On the other hand, an insufficient FCF for earnings growth can force a company to increase its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business

Free Cash Flow Per Share

One use of Free Cash Flow by the investors is to calculate the cash flow per share of a particular company.

Let's understand this in more detail...

Free cash flow per share (FCF/ Share):

As we saw earlier, Free Cash Flow is the cash earned by the company that can be actually distributed to the shareholders.

It signals a company's ability to repay debt, pay dividends and buy back stock - all important undertakings from an investor's point of view.

An in-depth methodology to calculate free cash flows of a company would be to adjust a company's increase or decrease in net working capital (current assets less current liabilities) to the above figure.

Free cash flow increases if the company manages to improve efficiency and consequently reduce the required working capital. This ratio implies the amount of free cash available per share.

It is calculated as follows:

FCF = Net Profit + Depreciation - Capital expenditure - Changes in Working Capital - Dividend

Therefore, FCF per share = (Net Profit + Depreciation - Capital Expenditure - Changes in Working Capital - Dividend) / Shares Outstanding

Price to free cash flow per share (P/FCF) is a valuation method which allows one to compare the FCF generated per share to its share price.

The higher the result, the more expensive is the stock.

Interpreting Free Cash Flow

A better FCF indicates better efficiency on the part of the company.

However, simply assessing the FCF based on its absolute value is not prudent. You need to also assess what components have contributed to the same.

Let us take a hypothetical example of two companies, A and B, both of which have garnered the same FCF for the current financial year.

Estimated Free Cash Flow

(Rs) Company A Company B
Net Profit 75 120
Add: Depreciation / Amortization 20 5
Less: Capital Expenditure 5 15
Add / (Less): Decrease / (Increase) 10 -10
in Working Capital
Less: Dividend 20 20
Free Cash Flow 80 80

Although they appear similar, if you delve a little deeper into these companies, there is a stark difference in their performances.

Company 'A', despite having lower earnings has benefited by adding back depreciation and decrease in working capital.

Company 'B' has invested in capex and working capital.

This indicates that while company 'B' is investing for future growth, company 'A' is not sufficiently geared up for the impending challenges.

This also means that investors in company 'B' can expect rewards in future while those in company 'A' should sit up and take notice of what is ailing it.

Free Cash Flow as a Step to Value Investing

One of the important steps in value investing pertains to valuations. It is most important of all the steps since valuations decide the action points (buy or sell) of investors.

Let us first understand what the legendary value investor Warren Buffett's perception of value is. Then we will have a look at how he calculates the intrinsic value of a stock and how free cash flows come in handy there.

What is Value?

To understand value, Buffett quoted a famous saying that 'a bird in hand is worth two in the bush'. In other words, investing is knowing exactly what you are paying for today rather than speculating and over-paying for you could possibly get in future.

To know the correct price to be paid, you need to assess the value of the underlying asset correctly.

Only when the investor understands the moat the business enjoys and the risks to it, can he determine the intrinsic value and price he would be willing to pay, with adequate margin of safety.

Free Cash Flows to Estimate Intrinsic Value of a Company...

Determining value is a tough task. That's because it involves forecasting future cash flows which in itself is a challenge. Discounting those cash flows at an appropriate rate gives us an estimate of value.

However, forecasting cash flows for a business is not easy because of the uncertainty involved with the future, unlike coupon bonds. Valuing coupon bonds is relatively easier since you know the coupon payments of future.

But that is not the case with businesses.

So, basically the mantra is to look out for businesses that resemble coupon bonds. This would make the valuation exercise easier.

In other words, businesses where forecasting future cash flows is relatively easier are the ones that should be on the radar.

For instance, it would be comparatively easier to predict the cash flows of a company like HUL than Bharat Heavy Electricals (BHEL) because of the kind of businesses they are in. While HUL's products have certainty of demand across economic cycles, BHEL's order book and project execution rates tend to be volatile.

Once you have the estimate of cash flows discount it with the appropriate interest rate and compare it with your purchase price. The decision then needs to be taken accordingly.

Predicting Cash Flows for Cyclical Businesses

Say you are looking at a business where forecasting free cash flow is difficult. For example, a capital-intensive business.

How do we forecast cash flows then? Also, what kind of discount rate should be used here considering the riskiness in cash flows?

Buffett feels that for cyclical business the estimates for cash flows have to be conservative. Also, since he focuses on long-term investing, the discount rate used is constant across securities.

That figure is arrived at by using the government bond rates. Add an appropriate premium over that and you are on the right track.

No complicated financial models with risk premiums, sensitivity analysis, scenario framework and betas are needed. Just simple logic and mathematics.

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Can Cash Flows be the Path to Better Valuations?

It is no wonder that FMCG majors like Nestle and HUL fetch steep valuations due to the consistency and nature of their free cash flows.

As the capex cycle turns, there would be hundreds of companies that are profitable. Yet they may not have the funds to undertake capacity expansion due to poor cash flows. Some may be bearing the burden of a high working capital cycle. Others may be servicing debt.

So even as you look for profitable businesses that could ride the economic and policy tailwinds, pay attention to cash flows.

There are plenty of businesses outside the FMCG sector with strong cash flows and are yet to get the valuations they deserve.

Better cash flows can be the path to better valuations for a company.

Free Cash Flows from a Sector's Point of View

As explained earlier, cash flows are dependent on the capital expenditure and working capital liabilities borne by the company.

However, this differs as per the dynamics of the sector in which the company is operating and should be seen in that light.

Sectors like banking require minimum expenditure on capex. Pharma, engineering, FMCG or commodity sectors require substantial amount in research and development (R&D) and capacity expansions.

Thus, you would find a banking stock trading at a very attractive price to free cash flow valuation, while an equally competitive IT stock trading at a higher valuation (due to lower cash flows).

Free Cash Flow and the Value of Capital

'Price is what you pay. Value is what you get.' - Warren Buffett

When analysing a company, it is important to understand that consumer choices are always changing, and businesses have to continuously adapt.

The best businesses are able deploy capital usefully and make a profit after accounting for all costs.

But how do we value capital?

Gene Callahan in Economics for Real People has stated that the value of capital is derived from the plans people have for it.

For example, some scrap metal lying on the floor has no value until somebody decides to melt it and use it to make productive machinery. Let's assume this metal is used to manufacture a small truck for delivering milk on a daily basis.

Can the value of this truck now be estimated with no further information?

The answer is no.

The truck is used for delivering milk, which results in some revenue. From this revenue, we need to account for costs incurred.

Common costs are the wear and tear of the truck, time invested delivering milk (labour costs), fuel, and other costs.

In the scenario this is generating a profit, what would be the value of this enterprise (truck + driver + standard delivery route)?

At this stage, some investors would start applying multiples and other methods to arrive at a ballpark price. However, my answer would still be no.

Taking this further, there is the cost of repairs and maintenance to the truck; maybe the axle is strengthened to increase load capacity. This typically pops as capital expenditure in a business. This represents cash that is ploughed back into the business to grow/maintain it.

With a clear understanding of profits, depreciation (wear and tear), and capital expenditure, we are now in a position to understand the 'free cash' generated from this small enterprise (for the sake of simplicity, working capital changes are ignored).

The above milk-delivery business generates a steady profit every year and uses a portion of that profit to maintain and grow the business.

The cash that remains is called free cash flow to equity (investor). This is a good indicator if you want to value a business.

Let us take a look at some numbers to make this clearer...

This milk-delivery generates a profit after depreciation and taxes of Rs 1 lakh. A portion of the profits are used to maintain the truck in running condition. To keep it simple, let's say the yearly depreciation is the same as the maintenance capex (no cash impact).

Assuming no growth and the business has a life of ten years (no residual value), what would this business be worth to you?

The business will produce free cash flow of Rs 1 lakh for ten years.

This is cash that can be pulled out of the business with no consequence to the future of the business. It has also been referred to as owner earnings by Warren Buffet.

Now we know the cash value of this business for the next ten years. Assuming your return expectation is 15%, a simple 'discounted cash flow' calculation will give the value of this business. You should be ready to pay anything below Rs 5 lakh to invest in this business.

Enterprise valuation is an art with many complexities. There is enough financial literature about price-to-earnings multiples, capital asset pricing models (CAPM), and beta calculations to occupy you for months. The above method is broad.

It has overlooked many complex questions such as: Why will the business be able to generate a steady profit for ten years? What is its moat? How can this business be grown into a fleet of delivery trucks? What will happen at the end of ten years?

A great business is like a virtual compounding machine.

It generates free cash and is able to reinvest this surplus at high rates of return.

To Conclude...

Free Cash Flow is not only a mirror image of the present but also a sneak preview into the future.

The implications of the components of cash flow may not be explained in the annual reports but is left to the investor's prudence to diligently scrutinize the same and try to read between the lines.

It would be great to remember here what the legendry investor Benjamin Graham once said...

    "The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase."

Here are Links to Some Very Insightful Equitymaster Articles Related to Free Cash Flow:

Price to Cash Flow (P/CF) Stock Screener

Now that you have read about cash flows, here's the million dollar question - Which Indian stocks are the most attractive according to the P/CF ratio? Indeed, this is a difficult question to answer... But we are here to help you get started! Just use Equitymaster's Advanced Stock Screener and you could find your answer right away!

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