Earnings, dividends, and asset values tend to get the most attention when it comes to stock price valuation. While they are important factors, a company’s ability to generate cash will eventually fuel growth in those factors. Due to differences in accounting practices across companies, slight variations in earnings calculations can make it difficult to track true earnings growth over time and compare figures between firms. On the other hand, free cash flow measures the cash a company generates after paying capital expenditures and dividends.
The components needed to calculate free cash flow are reported in a statement of cash flows that companies are required to file each quarter and fiscal year when filing their income statement and balance sheets.
A company’s cash flow statement reports the sources and uses of cash. On the cash flow statement, cash flow is the sum of total operating, investing, and financing activities plus any foreign exchange effects. Cash from operations represents how much cash is generated or consumed producing and selling the goods and services of the firm. Cash from investing deals with the cash used in infrastructure and includes the purchase and sale of long-term investments and property, plant and equipment. Finally, cash from financing deals with the capital funding of the firm and takes inflows from additional borrowing, repayment of debt, dividend payments, and equity financing into account.
Free cash flowmeasures excess operating cash a company has on hand after paying its capital expenditures and dividends. Free cash flow allows a company to pursue opportunities that enhance shareholder value—for example, increasing dividends, developing new products, paying off debt and buying back stock. In general, growing free cash flow may point to sustainable growth in earnings. In contrast, shrinking free cash flow may indicate trouble ahead as companies with insufficient cash flows try to internally fund their operations and growth.
However, a negative or falling free cash flow is not necessarily a sign of trouble provided it is temporary. A company may be gearing up for a product launch with high capital expenditures that will lead to future growth and free cash flow. It is important to look at the reasons for a company’s falling or rising cash flows.
Free cash flow is computed from the statement of cash flows and takes cash from operations minus capital expenditures minus dividends paid.
Capital expenditures and dividends are subtracted because they are real cash payments a company makes.
Some definitions of free cash flow do not deduct dividends from operating cash, based on the argument that companies are not required to pay dividends. However, once a company starts paying a dividend, the market expects it to keep paying a dividend and will typically react negatively if a company cuts or stops paying its dividend. Capital expenditures are also an important part of a business’ growth prospects. A company must, at a minimum, spend enough to maintain its level of business and upkeep on property and equipment. A company that fails to do this does not have a promising future.
Price to free cash flow is a valuation measure that compares a company’s current stock price to its level of annual free cash flow.
In general, a higher ratio of price to free cash flow per share means a company is “more expensive.” For example, a ratio of 2.0 means that the firm’s share price is double its free cash flow per share.
Analyzing the trend in a company’s price to free cash flow per share over time, as well as comparing it to industry and market benchmarks, is the best way to determine whether a stock is undervalued or overvalued.
Some investors use free cash flow per share as a proxy for earnings per share. Table 1 shows how to calculate free cash flow, price to free cash flow per share and free cash flow per share.
|Ratio||Formula||What It Measures|
|Free Cash Flow||Cash From Operations — Capital Expenditures — Dividends Paid||Cash flow a company can use to increase shareholder value|
|Price to Free Cash Flow per Share||Price ÷ Free Cash Flow per Share||The market’s expectations of future financial flexibility|
|Free Cash Flow per Share||Free Cash Flow ÷ Shares Outstanding||Alternative to earnings per share|
It can be hard to find cash flow statistics outside of the actual statement of cash flows. SmartMoney provides the actual free cash flow value for the trailing 12 months and the per share value as well. Enter a ticker symbol and choose Key Statistics (see Figure 1). Reuters provides a price to free cash flow ratio (see Figure 2). Enter a ticker symbol and choose Ratios.
Be aware that free cash flow can be calculated differently from site to site. Find out how the calculations are made before attempting a direct comparison.
Table 2 lists the components of free cash flow for the Walt Disney Company (cash from operations, capital expenditures and dividends) as well as free cash flow per share and earnings per share for the last five years.
In 2006, Disney saw a jump in free cash flow per share from $0.94 to $2.05. This was due to smaller capital expenditures on its parks and resorts ($1.8 million in 2005 to $1.2 million in 2006) and the decision to sell the licensing agreement to some of its retail outlets of The Disney Store, which boosted operating cash.
For 2008, Disney saw little growth in its operating cash, mainly due to flat earnings resulting from increases in expenses that offset rising revenues (year over year). Walt Disney had a fairly smooth pattern of earnings per share growth but a more disjointed pattern of free cash flow growth, with that big jump in 2006.
|Operating Cash ($M)||0.17||0.18||0.19||0.16||0.17|
|Capital Expenditures ($M)||0.05||0.05||0.04||0.07||0.05|
|Free Cash Flow ($)||1.64||1.54||2.05||0.94||1.19|
|Earnings, Diluted Continuing ($)||2.28||2.24||1.6||1.19||1.11|
|Source: Stock Investor Pro/Thomson Reuters. Data as of 8/31/2009.|
Walt Disney Company has a relatively stable growth in earnings and free cash flow.
For a company to grow, it must have enough cash to reinvest in the business. If this cannot happen, then earnings per share will have a hard time increasing.
Free cash flow is an important measure of a company’s growth potential. Even profitable companies, according to accounting standards, can go under if they do not have the cash needed to pay the bills. Furthermore, just because a company generates excess cash it does not mean the company will use it to the benefit of investors. Increasing free cash flows are good, but managers who know how to reinvest in the business are key players in turning excess cash into earnings growth.