Investors often review a company's free cash flow before deciding whether to buy a stake.
Free cash flow is cash that is generated by a company after certain cash costs—such as reinvestment in its operations through buildings and/or equipment—have been deducted, but before making any payment to bond or stockholders.
It is an important metric measuring the value of a company, and investors often turn first to free cash flow when they conduct due diligence during the investment decision-making process. For example, private equity investors are fixated on the amount of cash a company generates, followed by the amount of debt it holds. A company in manufacturing may not engage directly in making their products because they use contract manufacturers. It doesn’t need to invest heavily in buildings (i.e., manufacturing plants or warehouses) and equipment, but it ends up with lower capital costs.
Cash is typically generated from three areas: operations (such as revenue from goods or services), investing (providing loans), and financing (sale of stocks or bonds). Items that make up the calculation in free cash flow differ from company to company depending on the industry, and their formulas may not always be simple.
What Are the Uses of Free Cash Flow?
Companies typically pass on some of their cash to shareholders in the form of a dividend. Publicly traded companies can use the cash to repurchase stock in the open market on the premise that reducing the number of outstanding shares will increase earnings per share.
Cash management is an important tool, and utilizing or preserving cash differs by industry and the company’s growth. A company that is a start-up or continues to expand (or is in its growth stage), either organically or via acquisition, will quickly go through its cash.
In the formative years of Tesla, the carmaker used the cash it had on hand to invest heavily on new factories and equipment to produce as many electric vehicles it could each year. Tesla went public in 2010 but didn’t become free cash flow positive until 2019.
In Apple’s case, the company saved a lot of its cash generated from the sale of its popular iPods in the early 2000s, a lesson it learned after almost going bankrupt in the late 1990s. Also, Apple outsourced the production of iPods and other devices to contract manufacturers, reducing the need to spend heavily on new plants and equipment. Apple’s large cash pile, which started to exceed $100 billion, attracted activist investors who called for the company to pay dividends and buy back stock.
When investors seek to invest in a company, one important metric is the amount of money it generates in specific, regular periods over time.
How Do You Calculate Free Cash Flow?
The basic formula for free cash flow is cash from operations minus capital expenditures. Each company has their own method of presenting their financial statements, and capital expenditures don’t always show up as an item. That must then be calculated from other items on the company’s balance sheet and income statement.
Frequently Asked Questions (FAQs)
The following are answers to some of the most common questions investors ask about free cash flow.
What Is the Free Cash Flow Hypothesis?
When a company has too much cash on hand, executives tend to make poor investment decisions, and they spend impulsively—only to end up in ventures or projects that become unprofitable. That’s in contrast to a company being highly leveraged, which pushes management to be frugal and diligent about its finances and investment decisions.
Is Free Cash Flow the Same as EBITDA?
EBITDA (earnings before interest, tax, depreciation and amortization) is a metric that is a measurement of value, but is different from free cash flow. For example, EBITDA doesn’t account for capital expenditures, which free cash flow does.
What Is Discounted Free Cash Flow?
Discounted free cash flow is a company’s enterprise value plus future cash flows over a specific period in time, discounted by its weighted average cost of capital, which is the average cost across equity, debt and preferred shares.
Is Free Cash Flow Cumulative?
Cash that is left over from the previous accounting period is combined with the net cash position of the latest period.
Can Free Cash Flow Go Negative?
Free cash flow can be negative if the company is spending more than the capital it can raise through equity or bond sales, or burn through the cash it generates.
