The Eagerly Anticipated Tutorial on Calculating Free Cash Flow, Part 1
Since there is interest, I thought I would attempt to offer a brief tutorial on free cash flow - what it is, how it is calculated, and how it can be used to approach the calculation of the intrinsic value of a company. I am not the best person to do this, but I hope I can make it clear enough that those who haven't used it will try it, and will be able to ask me questions about those parts that aren't clear. I also hope (and trust) that those who don't need the tutorial will clarify and correct what follows, for the benefit of those do wish to understand.
What is Free Cash Flow?
Free Cash Flow (FCF) is a measure of the money a firm makes over and beyond what that firm needs to maintain and grow their business. It might be thought of as their discretionary income. After all the expenses are paid for producing their product, and for maintaining their factory, and gearing up to sell next year's product, a firm with positive FCF will have some money left over. This money is the money that can be removed from the company without affecting its business. This is a key concept. Most valuation tutorials will talk about how buying a share in a public corporation entitles you to a share of those earnings. This is true, but misleading; if those earnings were removed from the corporation, it might impact the business. I will explain this in a bit. For now, just note that this free cash flow is truly discretionary, and that you can gain valuable insight into management by watching what they do with any free cash flow. Do they invest in other businesses with cash? Do they purchase their own shares?
Now I am going to give you a simplified mathematical definition of free cash flow. That is to say, I am deliberately leaving out some factors (which you will find in more complete treatments) for the simple reason that 1) they aren't needed to explain the concept, and 2) with most companies, they are of much lesser importance than the factors I will include. For practical purposes, IMO, they can usually be safely disregarded. So I will do this simply to make it accessible to all.
Free Cash Flow = Cash Flow from Operations - Capital Expenditures.
Cash flow from operation is the net money which results from a company's line of business. It includes the earnings you see reported, hence it reflects the sales of product and cost of producing product. Capital expenditures is the money the company must spend on its infrastructure to remain in operation and to expand if need be. This is a key concept - the cost of maintaining and building the physical parts of the company, which are required to produce product, is not included in calculating the cost of producing the product.
Perhaps a brief comparison to earnings, with a personal analogy, would clarify this point. When you fill out your tax forms (that should be fresh in everybody's mind) you go through a lot of steps and eventually reach an adjusted income upon which you should be taxed. That is the equivalent of a company's gross (pre-tax) earnings. If you took that number, and then subtracted the tax you paid, you would have your net income, the equivalent of a company's reported earnings. Now note a couple of things about this. When doing your taxes, you tried to minimize your gross earnings number so as to reduce your tax liability. Public corporations do the same thing, but they have the competing motive of wanting to please their shareholders. Their dilemma is to keep as much money as possible (reduce taxes) but impress the investing public (show big profits). A private corporation, like an individual, would probably seek to show as little profit as possible. The next thing to note is that your earnings (your taxable income minus the taxes you paid) really don't reflect how much discretionary money you have. For example, in order to earn that gross income, perhaps you have to drive to work, which has many expenses. The cost of owning and maintaining and operating a vehicle is necessary for you to earn your income, yet (for most) those expenses are not used in any way to calculate your income, either pre-tax or post-tax. It is the same way with corporations.
In case it wasn't clear enough from the above paragraph, FCF can be higher than reported earnings (good) or lower than reported earnings (bad). Some companies, just like some individuals, manage to make more real profit (FCF) than reported profit (earnings) and some report more earnings than they have FCF.
Positive free cash flow is true excess money generated by a business which can be used to do something good - reward the owners, invest elsewhere. Negative free cash flow is not so good. The company or individual must find some other way to finance their operations. An individual with negative free cash flow can take on debt (as can a company) but they probably can't put new money into gorilla gaming. A company can also issue more shares to raise cash. But either an individual or a corporation can and do get into trouble if their business conditions turn bad for a year or so.
I'm sorry this has been so long. I don't know how much detail valuation novices would like, and because its been so long since I was in your shoes, I probably am well out of tune with what is necessary and what is sufficient make this clear. By all means, ask me, challenge me, and if anybody sees a mistake, correct me.
In Part 2 I will cover how you can use this to estimate the intrinsic value of a company. Until then, here is a little exercise for those who wish to test themselves on the above. Take any company of your choosing, and calculate its free cash flow for the past year. Look at the Statement of Cash Flows, and find the lines "Cash Flow from Operations" and "Investments in Plant Properties and Equipment" (or some similar variant) which is how Capital Expenditures are often listed. You can also look at S&P report sheets, which have lines for Cash Flow and lines for Capital Expenditures, as do Value Line reports, to see how a company has done over several years. This will not teach you to do it on your won, but it is handy to see how a company has done historically.
While you can use any company you choose, I will mention three companies that interest people on this thread which may be useful to illustrate some of the concepts discussed above:
CREE - has consistently been free cash flow negative and reports earnings greater than free cash flow
GMST - free cash flow and earnings are roughly the same
JDSU - reports negative earnings yet has positive free cash flow.
I hope this helps more than it confuses and bloats!
- Pirah
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