Free Cash Flow is the cash that remains after a company pays to support its operations and capital expenditure. It tells you how much cash a company is generating after paying the costs to remain in business.
While net income is used to measure profitability, Free Cash Flow provides insights into a company’s business model and financial health.
Abbreviations:
- Free Cash Flow (FCF)
- Free Cash Flow to Equity (FCFE)
- Free Cash Flow to the Firm (FCFF)
- Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA)
Aswath Damodaran, professor of finance at the Stern School of Business, New York University, explains:
I am someone who believes that intrinsic value comes from expected cash flows. While I understand that there is no one overriding definition of cash flow that trumps others, it is essential that we define what we mean when we talk about free cash flow.
FCF is one of the most dangerous terms in finance, and I am astonished by how it can be bent to mean whatever investors or managers want it to, and used to advance their sales pitches.
I have seen analysts and managers argue that adding back depreciation to earnings gives you FCF, an intermediate stop, at best, if you truly are intent on computing FCF. I have also seen FCF measures stretched to cover adjusted EBITDA, where stock-based compensation is added back to EBITDA.
Any measurement of FCF has to begin with a definition of to whom those cash flows accrue. Since a business can raise capital from owners (equity) and lenders (debt), the FCF that you compute can be to just the equity investors in the business, in which case it is FCFE, or to all capital providers in the business, as FCFF.
FCFE is the cash flow that a business generates after taxes, reinvestment and debt payments (interest and principal).
FCFF is a pre-debt cash flow, before interest payments and debt repayments or issuances, but still after taxes and reinvestment. An alternate way of describing free cash flow to the firm is that it measures the cash flows that would have been available for equity investors, if there were no debt in the firm, and it is for this reason that some call it an unlevered cash flow.
There are facile reasons that you can give for computing FCF, including the usual “we don’t trust accounting earnings” and “cash is king”. However, there are three places FCF can be used:
- The first is that is that computing FCF for a past period helps in explaining what happened at a business during that period, in operating, investing and financing terms.
- The second is that it is that the FCF that you compute for a past period can be used as the basis for forecasting expected free cash flows in the future, a key ingredient if you are doing intrinsic valuation.
- The third is to compute the FCF as a base to be used to compare pricing across companies, where the market price is scaled to FCF, rather than to earnings.
Since each of these missions has a different end game, there can be consequences for how we estimate FCF in each one.
The above is an extract from A Primer on Free Cash Flow
