Free Cash Flow

Free cash flow (FCF) is the cash a company generates from its operations after paying for the investments needed to maintain and grow the business. It is the money available to repay debt, pay dividends, buy back shares or make acquisitions. Many investors consider free cash flow the most honest measure of a company's financial performance, because it is harder to manipulate than accounting profit. It is also the foundation of discounted cash flow valuation.

The basic formula#

free cash flow = cash from operations - capital expenditures

Both figures come from the cash flow statement. See Cash Flow Statement and Capex, Depreciation and Amortization.

Variations#

Worked example#

Free cash flow yield#

FCF yield = free cash flow / market capitalisation

FCF yield is like an earnings yield based on cash. A higher yield can indicate a cheaper stock, though it depends on growth and risk. Investors compare FCF yields with bond yields and across companies. See Valuation Basics.

FCF conversion#

FCF conversion = free cash flow / net income

Conversion near or above 100% suggests profits are backed by cash. Persistently low conversion can signal heavy reinvestment needs, working capital problems or aggressive accounting. See Earnings Quality and Cash Conversion.

Maintenance vs growth capex#

Not all capital spending is equal. Maintenance capex keeps existing operations running; growth capex expands capacity. A fast growing company may show low FCF because it is investing heavily for future returns, which is not necessarily bad. Analysts sometimes estimate "owner earnings" (a term popularised by Warren Buffett) using only maintenance capex. See Capex, Depreciation and Amortization.

What companies do with FCF#

Common pitfalls#

• Ignoring stock based compensation, which is real dilution.
• One off working capital boosts, such as delaying payments to suppliers.
• Leases: lease payments may sit in financing, inflating FCF.
• Cyclical peaks: commodity companies can show huge FCF at the top of a cycle.
• Capitalising costs to push spending out of operating cash flow.

Free cash flow over a full cycle#

Because free cash flow can swing from year to year with working capital and investment timing, many analysts look at the average over several years, or over a full business cycle for cyclical companies. A single strong year is less informative than a consistent record of turning profit into cash.

Frequently asked questions#

What is free cash flow?#

Cash from operations minus capital expenditures: the cash left after running and investing in the business.

Why is free cash flow important?#

It shows the cash available for dividends, buybacks, debt repayment and acquisitions, and is harder to manipulate than net income.

What is a good free cash flow yield?#

It depends on growth and risk, but yields well above government bond yields often indicate a stock may be inexpensive, while very low yields usually reflect high growth expectations.

Next, learn how short term assets and liabilities affect cash in Working Capital.