Market Minute - March 31, 2017
by Scott Rosenquist, CFA
Free Cash Flow
One sign of a healthy business is the amount of cash it produces from its operations. The cash from operations minus any investments to maintain the business (capital expenditures) is considered free cash flow (FCF).
This is an important metric to many investors as it gives a company ways to increase value to shareholders. Companies that generate a lot of free cash flow have options on how to spend it. It could be used to pay a dividend, pay down debt, buy back its own shares, buy another company or invest back into the business. It is then up to company management to make wise decisions in allocating capital.
Free cash flow has a few benefits compared to using earnings when evaluating a company. Cash flow can be harder to manipulate than earnings and is not subject to as many accounting allowances. A company can report negative earnings and stay in business for a while but it still needs to generate cash to pay wages, suppliers, and keep the lights on. This metric can also be expressed relative to a stock price similar to the P/E ratio by substituting earnings with FCF (P/FCF). This ratio should be compared with companies in the same industry since each industry has its own dynamics that drive free cash flow. A software company and a heavy industrial company will have different levels of free cash flow that are considered normal.
There is no single metric to rely on when analyzing investments, but free cash flow is one of the more useful measures to look at. The old saying “cash is king” often refers to the importance of this metric in any business.
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