Roughly 90% of an iceberg is below the waterline, and ignoring what lies under the waves is equivalent to shooting oneself in the foot.
Many investors often make decisions based on figures such as revenue, net profit, and P/E ratios.
However, these metrics paint an incomplete picture of financial health, and fail to account for the inner workings of corporate finance.
Comparatively, free cash flow (FCF) is one of the key metrics that determine a company’s ability to respond to headwinds and take advantage of opportunities.
What Exactly Is Free Cash Flow (FCF)?
Before explaining why a company’s FCF is uniquely important, we must first establish what it is. Fundamentally, it is defined by the cash a company generates after covering its operating expenses and capital expenditures (capex).
Expressed as a simple formula:
FCF = Operating Cash Flow – Capital Expenditure.
A company’s operating cash flow is determined by the cash it generates from core business activities, while capital expenditure is the money it spends on acquiring or maintaining fixed assets like land and equipment.
How, then, does this differ from common measures such as profit?
A company’s FCF can be conceptualised as the capital that it generates after the cost of maintaining and expanding existing assets, on top of regular business expenses.
Therefore, it is not a function of accrual accounting, but instead tracks the actual available cash that a company has for expanding business operations or paying dividends.
Why FCF Matters More Than Earnings
All of this is extremely significant for investors.
Earnings can be manipulated or at least framed disingenuously, but a company’s cash flow is tangible and hence harder to fake.
FCF shows whether a company generates enough cash to pay dividends, buy back shares, repay debt, and expand its business.
For instance, companies such as iPhone maker Apple (NASDAQ: AAPL) convert a large portion of their earnings into consistent FCF, an indication of long-term financial health.
What Strong FCF Tells Investors
Specifically, a high FCF signals financial health, dividend sustainability, and flexibility.
Having cash on hand means that companies are able to consistently expand, weather financial downturns, and adapt to changes in a competitive environment while also being able to sustain a regular dividend.
Examples include tech titans such as Apple and Microsoft (NASDAQ: MSFT), both tech giants in their own right who have been steadily growing for the past decade.
Therefore, FCF is often a reliable indicator of a company’s ability to continuously create profit for shareholders.
What Weak or Negative FCF Signals
When a company has a low FCF, however, it can be a significant cause for concern.
Insufficient FCF often indicates that too much reinvestment is required to keep the business competitive, with sparingly little capital left for other additional expenses.
Furthermore, this indicates rising capital expenditure that is eating into cash, which can often cause debt-related issues to arise.
To be sure, the lack of FCF is not unequivocally harmful.
Historically, high-growth companies such as Amazon (NASDAQ: AMZN) and Tesla (NASDAQ: TSLA) may report lower or even negative FCF temporarily when they prioritise expansion in the short term.
It thus becomes important that investors are able to differentiate between strategic reinvestment and structural weakness,
How Investors Can Use FCF in Stock Analysis
Investors can utilise FCF to evaluate the value of a stock in a few ways.
Examining its FCF over several years is a good way to ensure continued strength, and the FCF margin (FCF divided by revenue) is also prudent to see how well the business turns sales into actual cash.
When it comes to valuation, it is important to focus on FCF rather than earnings by looking at a company’s price-to-FCF ratio.
This is a relatively reliable measure of a company’s market value compared to its available capital, making it a good tool for value investors.
Get Smart: Follow the Cash
Understanding FCF helps investors avoid yield traps, overleveraged companies, and the empty illusion of profit.
In a world of different financial metrics and wildly varying ways to evaluate a stock’s value, what should you believe?
At its core, the clearest measure of a company’s strength is the cash that it is able to use.
So, look past accounting noise and focus on the number that rarely lies: FCF.
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Disclosure: Daniel does not own shares in any of the companies mentioned.
