Companies with a lot of free cash flow are favored by savvy investors. It indicates a company’s capacity to make major financial commitments, including debt repayment, dividend payments, stock buybacks, and business expansion. These are all crucial tasks from the viewpoint of an investor.
How does free cash flow work?
After paying the costs associated with maintaining or growing its asset base, a company’s free cash flow is the amount of cash it can still earn. Another way to think about it is as the money that is on hand to pay back debts and reward investors with dividends and interest.
Depreciation is used to account for capital expenditures, so it may seem strange to add it back. The justification for the change, however, is that free cash flow is intended to assess money being spent/earned in the present, not transactions that took place in the past. This makes FCF a good tool for spotting emerging businesses with significant upfront costs that may have an impact on profitability now but have the potential to improve earnings later. When the company’s free cash flow is positive, it means it is making more money than it needs to operate and reinvest in order to expand. The inability of the corporation to generate enough cash to support the business is shown by a negative free cash flow statistic.
Objectivity of Free Cash Flow
- A company’s ability to pursue possibilities that raise shareholder value is made possible by free cash flow, which is crucial.
- Development of new products, acquisitions, dividend payments, and debt reduction are difficult without cash.
- Free cash flow is a more difficult metric to manipulate than net income, hence some investors prefer using it to gauge a company’s financial performance.
- It’s vital to keep in mind that a negative free cash flow does not, on the surface, seem to be a terrible thing.
- It may indicate that a business is making significant investments if free cash flow is negative. In the long run, the plan might be profitable if these assets generate high returns.
Making a Free cash flow calculation per share
Calculating the cash flow per share of a specific company is one way that investors use free cash flow. The amount of money a firm makes that can actually be given to its shareholders is known as free cash flow. It indicates a company’s capacity to pay off debt, distribute dividends, and repurchase stock—all significant tasks from the perspective of an investor. An elaborate way for calculating a company’s free cash flows is to add or subtract changes in net working capital from the aforementioned amount. If the business is successful in increasing efficiency and lowering the required working capital, free cash flow rises. The quantity of free cash that is accessible per share is implied by this ratio.
A Step Toward Value Investing: Free Cash Flow
The valuation process is one of the crucial processes in value investing. Since values determine the investors’ next steps, it is the most crucial step. Value assessment is a difficult task. This is due to the fact that it requires anticipating future cash flows, which is a difficult task in and of itself. We can calculate an estimate of value by discounting those cash flows at a suitable rate. Contrary to coupon bonds, anticipating cash flows for a corporation is difficult due to the future’s inherent uncertainty. Since you are aware of the anticipated future coupon payments, valuing coupon bonds is comparatively simpler.
However, this is not true of enterprises. Businesses that make it relatively easy to predict future cash flows should be paid attention to. When you have a rough estimate of your cash flows, discount it using the proper interest rate and then compare it to the cost of your purchase. The choice must then be made appropriately.
Free Cash Flow’s drawbacks
- Investments in capital assets with a long lifespan may be rare, but when they do happen, they can be expensive. Thus, Free cash flow will fluctuate greatly from year to year.
- Investors should therefore keep a close check on businesses that have high Free cash flow levels to determine whether they are underreporting their investment in R&D and capital expenditures.
- Extending transactions, tightening payments procedures, and depleting inventories are further ways that businesses can momentarily increase Free cash flow. To find businesses that are earning Free cash flow on a sustainable basis, do your research.