Why Free Cash Flow Matters More Than Earnings
When evaluating publicly traded companies, many investors look at the earnings of that company. However, experienced investors pay closer attention to the company’s free cash flow. While earnings tell you how much money a company makes, free cash flow tells you how much money a company produces after paying for the costs of the business.
A company can make a lot of money but produce very little cash. On the other side of the coin, a company may not produce a lot of earnings but could produce a significant amount of free cash flow. Institutional investors look at free cash flow as one of the most important indicators of the quality of a business.
What Is Free Cash Flow?
Free cash flow is the amount of money a company produces after it pays for its operating expenses and capital expenditures.
Free cash flow can be used for a variety of purposes, such as:
Investing in the company
Repaying company debt
Paying dividends to shareholders
Repurchasing company shares
Creating a cash reserve
Acquiring other businesses
Whereas earnings report on the financial results of a company according to accounting standards, free cash flow focuses on the actual cash in and out of a company.
Why Earnings Don’t Tell the Whole Story
Earnings are calculated using accounting standards that include non-cash items.
Companies’ earnings may not reflect the amount of cash they generate. Some of the reasons earnings and free cash flow might not match are:
Changes in the company’s working capital
Deferred revenue
Changes in inventory
Capital expenditures
Non-cash accounting adjustments
Ignoring free cash flow and focusing on earnings might make investors miss essential financial facts about the company.
Free Cash Flow Supports Shareholder Returns
Companies with strong free cash flow can use that cash for a variety of purposes to benefit their shareholders. These purposes may include:
Increasing the company’s dividend payments
Repurchasing company shares
Making acquisitions of other companies
Research and development
Repaying company debt
Companies that produce little cash cannot offer their shareholders the same opportunities as companies with strong free cash flow.
Capital-Intensive Businesses
Not all companies produce free cash flow in the same way.
Some capital-intensive companies need to invest a lot of money to start and sustain their operations. These industries include:
Manufacturing
Utilities
Telecommunications
Energy
Transportation
These companies have higher capital expenditures. Therefore, their free cash flow will be lower even when they are running well.
Free cash flow should be evaluated within the context of each industry.
Free Cash Flow and Business Quality
Many professional investors consider the amount of free cash flow a company produces one of the hallmarks of the quality of that company’s business.
Businesses that produce a lot of free cash flow usually have:
High pricing power
High operational efficiency
High demand for their products
High profit margins
Excellent management practices
Companies can invest in their business and industry when the market is down while others struggle to invest in their areas of expertise.
A company that produces strong free cash flow has competitive advantages.
Valuing Companies Using Free Cash Flow
Free cash flow is essential when valuing a company.
Investors look at a variety of metrics to determine the value of a company’s free cash flow. These metrics include:
Free cash flow yield
Price-to-free-cash-flow ratio
Discounted cash flow (DCF) models
Cash conversion rates
These metrics give investors an idea of a company’s future free cash flow rather than its earnings.
Many institutional investors look at free cash flow in every investment decision they make.
Warning Signs Investors Should Watch
There are a few warning signs that investors should be aware of when investing in a company.
Some of these warning signs are:
A falling operating cash flow
Rising capital expenditures
Increasing company debt
A negative free cash flow
Declining profit margins
A single weak year for a company will not necessarily raise an investor’s concern. However, warning signs that present themselves over a few years need to be analyzed more closely.
Warning signs for companies’ financial health will show up in free cash flow reports before they do in earnings reports.
Combining Free Cash Flow With Other Metrics
The financial measure of a company’s free cash flow should not be analyzed in isolation.
Other financial metrics to analyze a company include:
Revenue growth
Return on invested capital
Company debt
Company gross margins
Company earnings growth
Company capital allocation strategy
A variety of financial metrics provide a more complete picture of a company’s financial health.
No financial metric tells the whole story about the health of a company.
Key Takeaways
Free cash flow is the cash a company produces after capital expenditures.
Free cash flow tells the investor a company’s financial strength better than earnings.
A company with strong free cash flow can offer dividends to shareholders and use the free cash to enable future growth.
Capital-intensive companies require additional analysis due to their capital expenditures.
Professional investors use free cash flow in various valuation models.
High-quality companies produce a lot of free cash flow.
Conclusion
Free cash flow is the most valuable tool in the investor’s toolkit today. Companies that produce strong free cash flow have more financial flexibility to invest in areas that will benefit the company in the long term. These companies are more likely to provide investors with strong returns over time. Understanding free cash flow is an essential part of any investor seeking a long-term return on their investments.