Investing Intelligently: Part 5 (Examining a Company's Free Cash Flow)

Last time we identified a couple important things to look out for on the Balance Statement. It wasn't an all-inclusive list, but rather a quick way to identify important financial attributes of a prospective investment.

Sticking with this same approach, next we will take a look at the company's Cash Flow Statement to calculate an important metric frequently used by investors: Free Cash Flow (FCF). In simple terms, a company's FCF for the year or for a quarter, tells you how much cash the company has left in a period after it has accounted for all of its expenses that were required to pay for its ongoing operations and for growth. The calculation is a quick way to tell you about the company's financial health; cash is king in business. A company with a healthy amount of FCF can use its cash to pay out dividends or buy back stock or acquire another company or expand its operations. All of these things can reward you as a shareholder.

The basic calculation for FCF is simple. FCF = Cash Flow From Operations - Capital Expenditures. This calculation can be made more complex by factoring in other things, but if you use this simple formula, it will tell you basically what you want to know. So, if you pull up a company's Annual 10-K or Quarterly 10-Q on SEC.gov, in it you will find a Statement of Cash Flows. On the Statement of Cash Flows, you should find a line that reads something like this: "Net Cash From Operating Activities" or "Operating Cash" or "Cash From Operations" or something to that effect. Also on the Statement of Cash Flows, you should find a line that reads "Capital Expenditures" or "Additions to Property and Equipment" or something similar; capital expenditures are basically the costs for new buildings or manufacturing plants or equipment -- what the company purchases in order to expand its operations.

Like most financial data, in a vacuum the info is of little use. We want to put the company's FCF in context. So, for example, let's say we have calculated Company X's free cash flow for each of the last three to five years. This would give us an idea of how Company X's free cash flow is trending.

We can also take Company X's FCF for the past year (or trailing four quarters) and use it in another simple formula: Enterprise Value divided by FCF --> EV/FCF. Enterprise Value (EV) is a quick way of calculating what the company is currently being valued at on the stock market. A simple EV calculation is this: EV = Market Capitalization + Long-term Debt - Cash & Equivalents. We've gone over Long-Term Debt and Cash & Equivalents (Short-term or Marketable Securities). A company's market cap is easy to calculate: it is the current price of its stock multiplied by the total number of diluted shares outstanding. Instead of the Price to Earnings Ratio (PE), most investors find that the EV/FCF more accurately paints a picture of the company's current price on the market (its EV) in comparison to its free cash flow for the past 12 months.

With the EV/FCF ratio we can then look at how Company X is priced in comparison to the EV/FCF of its competitors. So, let's say Company X has an EV/FCF of 12, while Company Y's EV/FCF is 10. On the face of these figures, it would appear that Company Y is cheaper. But if Company X is growing faster than Company Y, then Company X is deserving of a higher multiple -- and it may be cheaper after all. Consequently, we want to know how Company X's EV/FCF measures up against its projected annual growth (G) rate over the next year or so; an easy ratio to use is EV/FCF/G. Once we have an idea of how Company X's EV/FCF compares to its projected growth rate, then we can use this info to compare it against its competitors. Going back to our example: let's say Company X's projected annual growth rate is 12% for the next few years, giving it an EV/FCF/G of 1; let's say Company Y's projected annual growth is only 5% over the next few years, giving it an EV/FCF/G of 2. Based on these calculations, Company X, with EV/FCF/G of 1 is a better value for investors.

Finally, Company X's current EV/FCF can be compared against its EV/FCF in previous years. This may tell you if the market is currently over-pricing or under-pricing Company X's stock in comparison to prior years.

Next, we will look at another ratio investors frequently use: Return on Invested Capital (ROIC).

Peace

Jeremy