Free cash flow should be an important consideration for any investor. Warren Buffett, one of the most successful value investors of all time, considers this his most important metric. Despite its utility, not everyone understands how it works. While it has a unique resistance to “creative” accounting techniques, it can have some drawbacks as well (especially for younger companies).
This article will take a look at what free cash flow is and how investors can incorporate it into their research process.
Free Cash Flow: An Overview
There is a saying that goes, “you can’t pay your bills with net income.” This is what makes free cash flow so important. In other words, so what if you made $10 million last year in net income? If $9,999,999 is invested in long-term capital improvements (which is excluded from net income), your bills aren’t getting paid. It’s important to have excess cash on hand for financial viability.
Strong free cash flow means the company is generating a surplus of money at the end of the day, after all expenditures.
It is often noted that free cash flow is the metric that Warren Buffet built his career on. As a value investor, Warren Buffett likes to invest in companies that are priced lower than their worth. Taking a close look at debt and profit margins helps him do that, which is where free cash flow comes in.
The term “free cash flow” was originated in 1972 by Joel M. Stern (who also pioneered the concept of “shareholder value”) as an alternate measuring stick to earnings reports. He wanted a way to measure the amount of excess cash that a company generates at the end of a given fiscal year. Unlike “net income”, his metric takes into account the purchase of goods and any changes in working capital.
One of the most useful things about free cash flow is that it can reveal financial problems before they arise on the income statement.
How Is It Calculated?
Free Cash Flow can be calculated in a variety of ways, but here is the most basic:
Free Cash Flow = Net Profit + Non-cash expenses – change in working capital – capital expenditure
In other words, it’s the amount of cash generated after all outflows and operating costs, including non-cash expenses.
Here is an example:
Let’s say Adam’s Coffee Company grew sales by 10% in 2018 and has consistently made $1,000,000 per year for the past 10 years. This consistency looks good on paper, right?
However, free cash flow might reveal that coffee bean inventory is stockpiling in the storeroom and coffee cup vendors are demanding faster payments, as this impacts the company outflow.
This is how free cash flow can reveal a financial weakness that might not otherwise be seen on the income statement.
Why It’s Important
Many investors focus on earnings reports as the ultimate measurement of financial well-being. However, accounting techniques can be used to manipulate earnings statements. Free cash flow, on the other hand, is not manipulated by accounting techniques because cash is cash. If a company generates excess cash at the end of the year, free cash flow reveals it.
This is a powerful measurement of success and company viability, because excess cash gives a company more room to grow and pay shareholders.
Despite its usefulness, there can also be problems with relying on this metric. For example, it possess an inherent “lumpiness” in reporting. In other words, free cash flow can be wildly different from year-to-year depending on business activity. If a company buys expensive manufacturing equipment in the year 2015, that will have a big impact on that year’s reporting, and will not be smoothed out over the course of several years. Therefore, free cash flow tends to look better on older, more established companies that do not have a lot of the same business expenses that early-stage businesses have.
When reading this metric, investors should keep in mind the importance of looking at several years in conjunction, rather than just one.
Free Cash Flow As Part Of The Chaikin Power Gauge Rating
Free cash flow should be an essential part of any investor’s research process, which is why it is one of the most important factors in the Chaikin Power Gauge stock rating.
Chaikin Analytics members can drill down on “free cash flow” on any rated stock by clicking on the “Financials” component, where free cash flow is the fifth factor alongside “LT Debt to Equity,” “Price to Book,” and “Return on Equity,” “Price to Sales.”
Members can also pull up a Chaikin Power Gauge Stock Report on any rated stock to dig into more information on a stock’s assets and liabilities ratio, valuation, and returns.
Want to find a list of stocks with strong free cash flow? Members can pull this up easily with the Chaikin Stock Screener, under Power Gauge Rating screening criteria.