Free Cash Flow: The Alternate Bottom Line

One of the themes that I continually emphasize with regards to fundamental analysis is an approach that treats net income as an ancillary, rather than primary, valuation metric. Instead, investors should use Free Cash Flow (FCF) as a starting point from which to assess a company.

Fundamentally, free cash flow is cash generated in excess of a firm's operating costs and capital expenditures (CapEx). Capital expenditures are investments a company makes in its property, plant and equipment. CapEx can be investment in new land, machinery etc., or substantial "repairs" such as putting a new roof on a building. Therefore, CapEx can simultaneously be thought of as investment necessary for growth of the business, and investment necessary for maintenance of the firm's assets. Free cash flow then, is a pure cash measurement that is indicative of the firm's ability to finance expansionary activities from internally generated cash. Conversely, negative free cash flow is potentially indicative of the need for future borrowing.

I prefer to take one additional step in the FCF calculation, and net out dividends. If a company regularly declares dividends, a real cash outlay will occur, and it will detract from the firm's ability to expand operations. You could argue that dividends are voluntary and can be reduced or eliminated; however, that would adversely affect the stock price as the market adjusted to the new, reduced stream of cash flows. The point is, be aware that there are varying definitions of free cash flow. An example of the FCF calculation for General Electric (GE), 2008 reported results follows:

Free Cash Flow = Operating Cash Flow - Capital Expenditures - Dividends
Free Cash Flow= ($48,601M - $16,010M - $12,408) = $20,183M

GE reported $17,410M for its 2008 net income, obviously a couple billion and change shy of its free cash flow generated for the year. The chart below looks at free cash flow v net income at GE and four other companies.
Despite the fact that Exxon (XOM) makes every other industrial corporation look like a mom & pop general store, a major observation to be taken from the chart is that FCF can be either greater, or less than, net income. I wouldn't lay out a bright line rule as to what the ratio between these two should ideally be; the ideal relationship will change depending upon the specific corporation. For instance, Wal-Mart (WMT) primary method of expansion is via construction of new stores, a cash outlay that is already netted out of the free cash flow equation. There might not even be any new ventures for which Wal-Mart would need to apply its free cash flow. A diversified conglomerate like General Electric however, must constantly venture into new business activities, thus necessitating ample free cash flow. The more important point is to look at the FCF trend over time, and within the context of the company's current status. Sphere: Related Content