Free Cash Flow: The Lifeblood of a Business
Revenue tells you what a company sells. Earnings tell you what accounting profits it reports. Free cash flow helps show how much cash the business actually generates after funding the investments required to operate.
Eventually, profits have to become cash.
A company can report impressive revenue growth. It can report rising earnings per share. It can even appear inexpensive based on traditional valuation ratios.
But at some point, the economics of the business need to translate into actual cash generation.
What is free cash flow?
At a high level, free cash flow represents the cash generated by a business after accounting for capital expenditures.
Capital expenditures—often shortened to capex—include investments in long-term assets such as factories, equipment, infrastructure, technology, and other resources required to maintain or expand the business.
In this simplified example, the company generated $1 billion of operating cash flow, invested $400 million into capital expenditures, and was left with approximately $600 million of free cash flow.
It represents capital management can potentially reinvest, use to strengthen the balance sheet, return to shareholders, or save for future opportunities.
Two companies can report the same profit and generate very different amounts of cash.
Net income is calculated using accounting rules. Free cash flow measures something different.
Working-capital changes, depreciation, capital expenditures, stock-based compensation, taxes, and other accounting items can create significant differences between reported earnings and actual cash generation.
Where can $1 of free cash flow go?
Once a company generates excess cash, management has choices. Those choices are collectively known as capital allocation.
Reinvest
Fund new products, factories, technology, research, employees, or market expansion.
Reduce Debt
Lower interest expense, refinancing risk, and financial leverage.
Buy Back Shares
Reduce shares outstanding and increase the ownership percentage represented by each remaining share.
Pay Dividends
Return a portion of the company's cash generation directly to shareholders.
Make Acquisitions
Purchase businesses, technology, customers, products, intellectual property, or market share.
Hold Cash
Build reserves for downturns, unexpected needs, or future opportunities.
Reinvest in the business.
Often, the highest-value use of free cash flow is to put the money back into the company.
That could mean opening new locations, expanding manufacturing capacity, developing new products, increasing research and development, investing in technology, hiring employees, or entering new markets.
But reinvestment only creates value if the company can earn attractive returns on the capital being deployed.
Strengthen the balance sheet.
Free cash flow can be used to repay debt rather than relying on outside capital to improve the company's financial position.
This can be especially valuable for cyclical businesses or companies operating during periods of higher interest rates.
A business capable of generating substantial internal cash flow may be able to repair its balance sheet without issuing additional shares or depending on favorable credit markets.
Repurchase shares.
Companies can use free cash flow to purchase their own stock.
If those shares are retired, the remaining shares represent a larger percentage ownership interest in the business.
If a company continues earning the same amount of total profit while the number of shares declines, earnings per share can increase.
Repurchasing undervalued shares can potentially create value for remaining shareholders. Paying an excessive price can destroy value.
A share repurchase is simply another investment decision.
Return cash directly to shareholders.
Mature businesses with relatively stable cash flows and fewer attractive reinvestment opportunities may distribute part of their free cash flow through dividends.
This allows shareholders to receive cash without selling shares.
Free cash flow can also provide useful context when evaluating whether a dividend appears financially sustainable.
Ask how much cash the company generates relative to how much cash it distributes to shareholders.
Acquire other businesses.
Strong cash generation can allow a company to acquire other businesses without relying entirely on borrowed money or newly issued shares.
But just as with share repurchases, price matters.
Buying an excellent business at an excessive valuation can still produce a poor return on capital.
Sometimes the best decision is to wait.
A company does not have to deploy every dollar immediately.
Retaining cash can help a business survive difficult periods, continue investing during downturns, avoid raising capital under unfavorable conditions, or react quickly when an attractive opportunity emerges.
A company that must continually access debt or equity markets is partially dependent on investors remaining willing to provide capital.
A business that generates substantial cash internally has more control over its own future.
Free cash flow can also help investors think about price.
One way investors compare a company's cash generation with its valuation is through free-cash-flow yield.
This is a simplified illustration. Investors may calculate free-cash-flow yields using different definitions of company value and cash flow depending on the analytical purpose.
The number becomes particularly interesting when considered alongside growth, balance-sheet strength, capital requirements, and management's ability to reinvest cash at attractive returns.
Not all free cash flow is created equal.
Simply finding companies reporting large amounts of free cash flow is not enough.
The quality and sustainability of the cash generation matter.
Temporary working-capital movements can make one year's cash flow look unusually strong.
Cutting necessary capital expenditures can temporarily boost free cash flow while weakening the business later.
Cash generation near the top of an economic or commodity cycle may not represent normalized earnings power.
Large buybacks may be partially offset by shares issued through stock-based compensation.
Generating cash is only one part of the equation. Allocating it intelligently is equally important.
The combination investors often want to find.
Some businesses have the ability to generate substantial free cash flow while still having attractive opportunities to reinvest that money.
A company that can repeatedly take internally generated cash and reinvest it at attractive returns may be able to expand earnings power without relying heavily on outside capital.
Free cash flow gives management choices.
Revenue matters.
Margins matter.
Earnings matter.
But eventually, investors want to understand whether the economics of the business are producing cash.
Accounting earnings do not directly repay debt, fund acquisitions, repurchase shares, or pay cash dividends.
Cash does.
That is why free cash flow is often described as the lifeblood of a business. It represents financial resources generated internally and gives management the flexibility to decide what happens next.
Look beyond the valuation multiple.
A low price-to-earnings multiple does not necessarily make a company inexpensive, just as a high multiple does not automatically make a company expensive.
We want to understand the economics underneath the valuation.
Those questions can help reveal the difference between a company that simply reports profits and one that consistently creates economic value.
Understand what is driving the investments you own.
Portfolio construction involves more than looking at ticker symbols and recent returns. Understanding the underlying businesses, valuation, concentration, fees, and portfolio risk can provide a much clearer picture.
This material is provided for educational and informational purposes only and should not be construed as individualized investment, tax, or legal advice or as a recommendation to purchase or sell any security.
Examples involving free cash flow, company valuations, share repurchases, capital expenditures, earnings, and free-cash-flow yields are simplified illustrations. Actual company financial statements and cash-flow calculations may differ materially based on accounting treatment, business characteristics, capital structure, working-capital changes, acquisitions, asset sales, stock-based compensation, and other factors.
Investing involves risk, including possible loss of principal. Historical or current cash generation does not guarantee future results.