Free Cash Flow Analysis
Master free cash flow—the ultimate measure of financial performance.
Learning Objectives
- Calculate and interpret free cash flow
- Understand different FCF definitions
- Use FCF to assess dividend sustainability
- Apply FCF in company valuation
Free Cash Flow Analysis#
Free cash flow (FCF) is arguably the most important metric for investors. It represents the cash a company generates that's truly "free"—available to return to shareholders or reinvest in the business.
Free Cash Flow = Operating Cash Flow - Capital Expenditures
This simple formula shows what's left after a company funds its operations AND maintains/grows its asset base.
Why Free Cash Flow Matters#
The Ultimate Reality Check#
- Net income can be manipulated through accounting choices
- Operating cash flow is better but includes mandatory reinvestment
- Free cash flow shows what's actually available after required spending
What FCF Funds#
| Use of Free Cash Flow | Description |
|---|---|
| Dividend payments | Cash returned to shareholders |
| Stock buybacks | Share repurchases |
| Debt reduction | Strengthening the balance sheet |
| Acquisitions | Growth through M&A |
| Cash accumulation | Building reserves |
Warren Buffett's View
Warren Buffett calls the cash available after necessary capital expenditures "owner earnings"—the money that actually belongs to shareholders. This is essentially free cash flow.
Calculating Free Cash Flow#
Basic FCF#
FCF = Operating Cash Flow - Capital Expenditures
Example:
- Operating Cash Flow: $500 million
- Capital Expenditures: ($200 million)
- Free Cash Flow: $300 million
Free Cash Flow to Equity (FCFE)#
More conservative—adjusts for debt changes:
FCFE = Operating Cash Flow - CapEx - Debt Repayments + New Debt Issued
This shows cash available specifically to equity holders.
Unlevered Free Cash Flow (UFCF)#
Used in valuation; adds back interest:
UFCF = Operating Cash Flow - CapEx + After-tax Interest Expense
This shows cash flow independent of capital structure.
FCF Analysis Framework#
1. Is FCF Positive?#
| FCF Status | Interpretation |
|---|---|
| Consistently positive | Healthy cash generation |
| Occasionally negative | Check if due to large investments |
| Consistently negative | Concerning—requires funding from elsewhere |
2. How Does FCF Compare to Net Income?#
| Comparison | What It Suggests |
|---|---|
| FCF > Net Income | High-quality earnings, low capital needs |
| FCF ≈ Net Income | Normal relationship |
| FCF < Net Income | Heavy reinvestment or low-quality earnings |
| FCF negative, NI positive | May be aggressive accounting |
3. What's the FCF Trend?#
| Trend | Interpretation |
|---|---|
| Growing FCF | Improving cash generation |
| Stable FCF | Consistent, predictable business |
| Declining FCF | Investigate cause—competition? Investment? |
| Volatile FCF | Project-based or cyclical business |
FCF Yield#
FCF Yield compares free cash flow to market value:
FCF Yield = Free Cash Flow ÷ Market Capitalization × 100
| FCF Yield | Interpretation |
|---|---|
| > 8% | Potentially undervalued (or troubled) |
| 4-8% | Reasonable yield |
| 2-4% | Modest yield (often growth stocks) |
| < 2% | Low yield (high growth expectations priced in) |
Context Required
High FCF yield isn't automatically good—it could indicate a declining business. Low FCF yield isn't automatically bad—growth companies reinvest heavily. Always understand the reason.
FCF and Dividends#
Free cash flow determines if dividends are sustainable:
FCF Payout Ratio#
FCF Payout Ratio = Dividends Paid ÷ Free Cash Flow × 100
| Payout Ratio | Sustainability |
|---|---|
| < 50% | Highly sustainable, room to grow |
| 50-75% | Sustainable with some buffer |
| 75-100% | Sustainable but tight |
| > 100% | Unsustainable—using other sources |
Example Analysis#
| Metric | Company A | Company B |
|---|---|---|
| Net Income | $100M | $100M |
| Operating CF | $120M | $80M |
| CapEx | ($30M) | ($60M) |
| Free Cash Flow | $90M | $20M |
| Dividends | $40M | $40M |
| FCF Payout Ratio | 44% | 200% |
Both companies have the same net income and dividends, but Company A's dividend is easily covered by FCF while Company B is paying dividends with funds from elsewhere (debt or asset sales).
FCF in Valuation#
Many professional investors value companies based on FCF rather than earnings.
Discounted Cash Flow (DCF)#
The DCF model values a company based on projected future free cash flows:
- Project FCF for future years
- Discount back to present value
- Sum all discounted cash flows
- Add terminal value
Price-to-FCF Ratio#
P/FCF = Market Cap ÷ Free Cash Flow
Similar to P/E ratio but uses cash instead of earnings.
| P/FCF | Interpretation |
|---|---|
| < 10 | Potentially undervalued |
| 10-20 | Moderate valuation |
| 20-30 | Premium valuation |
| > 30 | Expensive or high growth expectations |
Common FCF Adjustments#
Analysts sometimes adjust FCF for better comparability:
Maintenance vs. Growth CapEx#
Adjusted FCF = OCF - Maintenance CapEx Only
Treats growth CapEx as optional, showing what FCF would be without expansion.
One-Time Items#
Remove unusual items that distort normal cash flow:
- Large legal settlements
- Restructuring costs
- Unusual asset sales
Working Capital Normalization#
Smooth out volatile working capital swings:
- Adjust for seasonal patterns
- Remove one-time impacts
Red Flags in FCF Analysis#
| Red Flag | Concern |
|---|---|
| Negative FCF with positive NI | Earnings quality issues |
| FCF declining while revenue grows | Business becoming less efficient |
| Dividends exceeding FCF | Unsustainable payouts |
| Buybacks despite negative FCF | Poor capital allocation |
| Acquisitions funded by debt when FCF negative | Growing dangerously |
Key Takeaways
- Free Cash Flow = Operating Cash Flow - Capital Expenditures
- FCF shows cash truly available to shareholders
- Compare FCF to net income to assess earnings quality
- FCF Yield compares cash generation to market value
- Use FCF to assess dividend sustainability (FCF payout ratio)
- Growing FCF is one of the best indicators of business health
- Watch for companies paying dividends or doing buybacks with negative FCF