Free Cash Flow

Free Cash Flow

Free cash flow is the operating cash flow less any increase in working capital, less capital expenditures. The free cash flow figure is an important metric in valuing a company. Free cash flow can be used to pay down debt, make share buybacks and issue dividends. For many fund managers, this is an clearer metric on the company’s operating health than EBITDA.

In a previous article on net earnings, I did mention that net earnings, profitability should be complemented with free cash flow analysis. It is possible that a company may be profitable but at the same time, the company is burning up cash. Why? That is because it has capital expenditures and working capital changes to contend with. Hence, it is important to look at the free cash flows of the company as well. You can find these numbers in the cash flow statement. Eventually, what one should be looking out for is both positive earnings and free cash flow.

Example 1

Company A’s stock price has been beaten down mercilessly by the market during a recession. With its operations intact and a growing free cash flow over the next few years, chances are that the company’s share price would revert to its previous levels or higher as the management is able to do a share buyback at these prices.  It is currently trading at a price to free cash flow of 5 times in a recession. An options trader may want to use LEAPS in a situation like this to capture any upside in the stock price.

Read: The Balance Sheet