Today is the first of a series of posts dedicated to properly researching stocks. As you’re probably aware, it’s always important to do proper research on a company before purchasing shares of its stock. Buying a stock without doing your homework is akin to jumping into the cockpit of a plane without proper training. In either situation, you’re bound to get hurt.
What is free cash flow?
Free cash flow is one of the greatest ways to measure the profitability of a company’s business. Put simply, free cash flow is the money that a business has left over after paying employees, expenses, debt, taxes and capital expenditures. Free cash flow is often used to measure profits because it is harder to manipulate than earnings per share or net income. It is also excellent at communicating the degree to which a company can reward its shareholders via dividends and share buybacks.
How do you calculate it?
In order to calculate the free cash flow of a company you need a copy of their statement of cash flows. Luckily this information is easy to find and can be accessed in the firm’s 10-Q and 10-K filings. You can also find this quickly at Yahoo Finance. I’ll now run through an example with one of my current investments…below is the cash flow statement for Heinz (HNZ)…
Once you have the statement of cash flows handy, calculating free cash flow is an easy task. The formula goes like this…
Free cash flow = Cash flow from operations - Capital expenditures
Here’s what Heinz’s free cash flow has looked like over that past three years…
How can you use it?
Once you’ve calculated the free cash flow of a potential investment you want to look at a variety of things. First, is the number positive or negative? And is it increasing over time? Or decreasing? Any company worthy of your investment dollars should have a strongly positive number that is increasing over time. Obviously companies can have a bad quarter or year once in a while, so you’ll need to use your discretion here.
Next, compare the number you calculated to the amount the company pays out in dividends and stock buybacks. If the company is paying more out in dividends and buybacks than it’s generating in cash flow you may have a problem. Ideally you want to see that the business has excess cash flow that it can use to increase dividends and buybacks in the future.
Finally, look at the total amount of long-term debt on the company’s balance sheet. Assuming that the company’s cash flow remains the same in the future, calculate how long it would take for the company to pay off all its debt. The quicker they could pay off their debt the better. This is going to give you an idea of the business’s financial strength and ability to weather a downturn.
If your potential investment passes the free cash flow test than it’s certainly deserving of further consideration. Stay tuned for my next post in the Researching Stocks series where I’ll be showing you how to determine the shareholder friendliness of a business’s management. After all, what’s the point of investing in a business with great free cash flow if the company’s management isn’t going to share the wealth?
Thanks for the tutorial. Always good to get reminded of important financial metrics.
Can you discuss a couple of the different ways people define FCF? What are your thoughts on using a FCF yield vs. other return metrics? Thanks
FS, I debated including some info on calculating FCF yield and FCF per share but thought it might get too crazy for one post. I hope to revisit the topic again soon since I really believe FCF is one of the most important metrics to look at for an investment!
[...] This is the second of a series of posts dedicated to properly researching stocks. In my previous post, I examined how to calculate a company’s free cash flow. Today, I’m going to show [...]