Using free cash-flow

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As anyone who has run a business will tell you, cash-flow is different to profits. Profits are stated after notional debits and credits that don't involve actual movements of cash. Cash-flow, on the other hand, ignores these book entries and concentrates purely on the flows of cash into and out of a business.

Hence operating cash-flow (the cash-flow counterpart to operating profit) ignores depreciation, amortisation of goodwill, retained profits of minority owned companies, capitalised interest and any other concepts that are merely the result of accounting conventions.

Free cash-flow goes further.

In addition, it subtracts those items that a company cannot avoid paying if it wants to stay in business: interest, tax, and sufficient capital spending to maintain its fixed assets.

It's worth remembering that tax and interest deducted to arrive at free cash-flow are the amounts paid in the year in question. They may not coincide exactly with the amounts provided in the profit and loss account.

In the case of interest charges, the exact cash amount flowing out will depend on the timing of interest payments. Interest must be paid in full on the due date. Whether or not a company capitalises interest (that is, ignores it in the income statement) does not alter the reality that capitalised interest still represents a cash cost to the business.

The same is true of tax. Taxes on profits of one financial year may be paid, or partially paid, in the next one.

Free cash-flow also deducts so-called "maintenance" capital spending. This is the capital spending on fixed assets required to maintain the business's assets in good order, replacing those that are worn out. In the absence of any guidance from management in the report, it may be necessary to guess at this figure, perhaps assuming it will be roughly two-thirds of the total figure for capital spending.

The point about the free cash-flow calculation is it represents the amount of cash left over after all essential deductions have been made. Companies then have a choice about how free cash-flow is spent. It can be paid to shareholders in the form of dividends; used for acquisitions, used for share buy-backs, and used for straightforward "organic" capital investment in the business, or simply retained.

How a company spends its free cash-flow can be revealing about its view of future events. If it fears a recession, it may build cash: if it believes the economy will be strong, it may institute a share buy-back or make a big acquisition.

Peter says

The importance of free cash-flow is that it is one of the acid tests of a company's ability to survive difficult times and a much better yardstick for assessing the true value of a company's shares. Free cash-flow is a starting point for many valuation ratios, including discounted cash-flow, price to cash-flow (or its inverse, the free cash-flow yield). Some investors also look at free cash-flow expressed as a percentage of sales.

There are no hard and fast rules for interpreting numbers like this but in a bear market, or indeed at any other time, market capitalisation to free cash-flow should be well under a 10 times multiple and conversely a free cash-flow yield (free cash-flow as a percentage of market capitalisation) well over 10%.

Discounted cash-flow calculations are a different matter, because the valuation that comes out of them is highly sensitive to the assumptions that go in.