Category Archives: Free Cash Flow

Net Income vs. Free Cash Flow

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The world of free cash flow (FCF) and net income are intriguing. These two financial metrics often dance around each other, but they’re not quite the same:

  1. What Is Net Income?
    1. Net income (profit or earnings) represents the bottom line on a company’s income statement. It’s the total profit a company has made after accounting for all expenses, taxes, and interest.
    2. Net income is calculated as:
      Net Income=Total Revenue−Total Expenses
  2. What Is Free Cash Flow (FCF)?
    1. FCF is a powerful metric that goes beyond net income. It measures the cash a company generates from its operations minus the necessary capital expenditures (like buying new equipment or expanding facilities).
    2. FCF considers both cash inflows (from operating activities) and cash outflows (such as asset investments).
    3. The formula for FCF is:
      FCF=Cash Flow from Operations−Capital Expenditures
  3. Why Might FCF Be Higher Than Net Income?
    1. FCF can exceed net income for several reasons.
    2. Non-Cash Expenses:
      1. Depreciation and amortization are non-cash expenses that reduce net income but don’t directly impact cash flow. If these expenses are significant, FCF can be higher.
      2. Working Capital Changes: Changes in working capital (like accounts receivable, inventory, and accounts payable) affect cash flow. If a company efficiently manages its working capital, FCF can surpass net income.
      3. Capital Expenditures: FCF can be higher if a company has minimal capital expenditures (e.g., it doesn’t need to invest heavily in new equipment).
      4. Timing Differences: FCF considers the actual timing of cash flows, whereas net income is based on accrual accounting. Timing differences can lead to variations between the two.
  4. Why Does It Matter?
    1. Investment Decisions: Investors often focus on FCF because it reflects a company’s ability to generate usable cash. Higher FCF means more flexibility for growth, dividends, or debt reduction.
    2. Sustainability: A company with consistently positive FCF is better positioned to weather economic downturns or invest in future projects.

Media Perception: Media reports often emphasize net income, but understanding FCF provides a deeper insight into a company’s financial health.

Remember, while net income is essential, FCF tells us whether a company can use that income to fuel growth or weather storms. So, next time you analyze financial statements, watch net income and FCF—they’re like two dancers performing different moves on the same stage!

Free Cash Flow Yield

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Key variable: free cash flow yield.

Free cash flow (FCF) is one of the most important financial metrics you can study – especially if you’re a buy-and-hold investor. Free cash flow is the amount of money generated from a company’s operations minus any capital expenditures; it is the cash remaining after a company has paid its expenses, interest on debt, taxes, and long-term investments to grow its business.

Suppose a company generates more cash than it needs to run its business. In that case, it can do several valuable things, such as pay dividends, buy back its stock, acquire other companies, expand its business, and knock out its debts.

Free cash flow yield is thus free cash flow per share divided by the stock’s price.

By looking at operating earnings, free cash flow takes out one-time gains or losses that may obscure the actual state of a company’s business. It’s also less susceptible to the accounting gimmicks impacting a company’s reported earnings.

Many of the greatest investors consider free cash flow yield a key factor in analyzing a stock. There are limitations to any single metric, and free cash flow per share and free cash flow yield are no exceptions to that rule.

A company, for example, can have an extremely high free cash flow in part because it is putting off necessary capital expenditures. Similarly, a good company that makes significant capital investments one year may see its free cash flow take a hit but may benefit over the longer haul. That’s why it’s important to consider free cash flow along with a stock’s other fundamentals.

References:

  1. https://www.forbes.com/sites/investor/2013/08/08/four-free-cash-flow-yield-all-stars/
  2. https://www.kiplinger.com/slideshow/investing/t052-s001-10-stocks-to-buy-for-kingly-free-cash-flow/index.html

Discounted Cash Flow Analysis

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Discounted cash flow model can be used for financial valuation of a project, company, stock, bond or any income producing asset.

Discounted cash flow is a financial valuation method that calculates the value of an investment based on the present value of its future income or cash flow. The method helps to evaluate the attractiveness of an investment opportunity based on its projected future cash flows.

Free Cash flow to the firm (FCFF) means the amount of surplus cash flow available to a business after a it pays its operational expenses like inventory, rent, salaries etc. and also invests in fixed assets like plant and machinery, property etc. Cash is an important element of business. It is required for business functioning; some investors provide more value to cash flow statements than other financial statements.

Free cash flow is important metric as it tells about the company’s ability to deploy capital in future projects. Without cash, it’s tough to develop new products, make acquisitions, pay dividends, buyback shares and reduce debt. Also, as cash is difficult to manipulate compared to other variables, FCFF is more reliable indicator of a company’s performance than net earnings.

DCF model can be used for valuation of a project, company, stock, bond or any income producing asset. The DCF method can be used for the companies which have positive Free cash flows and these FCFF can be reasonably forecasted. So, it cannot be used for new and small companies or industries which have greater exposure to seasonal or economic cycles.

To use the Discounted Cash Flow Model to Value Stock:

Step 1 : Calculate the Free Cash flow to the firm

Step 2 : Project the future FCFF – You need to project the future FCFF for the next couple of years. You can analyze the historical data to understand the past FCFF growth trend. However, relying on historical data only won’t give you the right result, so consider the present financials as well as future potential of the company while projecting the growth rate. When conducting a DCF analysis, investors and businesses must make estimations for future cash flows and the future value of the investment. For instance, a company considering a new business acquisition must estimate the future cash flows from expanding its processes and operations with the acquisition. The estimates the company makes can help determine if the investment is worth the cost of the acquisition.

Step 3 : Discount the FCFF — Calculate the present value of this cash flow by adjusting it with the discount rate. Discount rate is your expected return %. The discount rate is one of the most important elements of the DCF formula. Businesses need to identify an appropriate value for the discount rate if they are unable to rely on a weighted average cost of capital. Additionally, the discount rate can vary depending on a range of factors like an organization’s risk profile and the current conditions of capital markets. If you are unable to determine a discount rate or rely on a WACC value, an alternative model may be more beneficial and accurate.

Step 4 : Calculate the Terminal Value — It is the value of the business projected beyond the forecasting period. It is calculated by assuming the constant growth of a company beyond a certain period known as terminal rate.

When valuing a business, the annual forecasted cash flows typically used are 5 years into the future, at which point a terminal value is used.  The reason is that it becomes hard to make reliable estimates of how a business will perform that far out into the future. There are two common methods of calculating the terminal value:

  • Exit multiple (where the business is assumed to be sold)
  • Perpetual growth (where the business is assumed to grow at a reasonable, fixed growth rate forever)

Step 5 : Add discounted FCFF with Terminal value and adjust the total cash and debt.

Step 6 : Divide the Figure calculated in Step 5 by the outstanding number of shares to find out the DCF Value.

Step 7 : Adjust the Margin of Safety to find out the Fair value. Margin of Safety provides discount for uncertainties in the business.

When assessing a potential investment, it’s important to take into account the time value of money or the required rate of return that you expect to receive.

The DCF formula takes into account how much return you expect to earn, and the resulting value is how much you would be willing to pay for something to receive exactly that rate of return.

  • If you pay less than the DCF value, your rate of return will be higher than the discount rate.
  • If you pay more than the DCF value, your rate of return will be lower than the discount.

The DCF formula is used to determine the value of a business or a security.  It represents the value an investor would be willing to pay for an investment, given a required rate of return on their investment (the discount rate).

When using the DCF analysis, determine the discount rate and have estimates for future cash flows. Apply these values in the DCF formula to create a future outline that details expected returns. If the results appear at or above a company’s initial projections for future cash flows, then investing can be beneficial. However, if the discounted cash flow formula results in a value below a company’s projected future returns, it may consider alternative investments.

References:

  1. https://www.finology.in/Calculators/Invest/DCF-Calculator.aspx
  2. https://corporatefinanceinstitute.com/resources/knowledge/valuation/dcf-formula-guide/
  3. https://www.indeed.com/career-advice/career-development/discounted-cash-flow

The Power of Dividends

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Dividends account for about 40% of total stock market return over time

Value of dividends

There are 2 ways to make money in the stock market: capital appreciation and dividends.

Capital appreciation—an increase in a stock’s price—gets most of the attention, but dividends can be surprisingly powerful.

Fidelity Investments’ research finds that dividend payments have accounted for approximately 40% of the overall stock market’s return since 1930.

What’s more, dividends can help prop up returns when stock prices struggle. For example, stock prices in the S&P 500 fell during the 1930s and 2000s, but dividends almost completely offset the decline. In the 1940s and 1970s, when inflation surged, dividends accounted for 65% and 71% of the S&P 500’s return, respectively.

“From a multi-asset income perspective, I am always seeking investments that pay a high enough level of current income to help cushion the blow during down markets. Conversely, in rising markets, this income component contributes to the overall total return of the investment. In this regard, companies that pay a sustainable and growing dividend have the potential to grow their income to keep up with inflation,” says Adam Kramer, portfolio manager for the Fidelity Multi-Asset Income Fund

References:

  1. https://www.fidelity.com/learning-center/trading-investing/inflation-and-dividend-stocks

Power of Dividends

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A dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend.

Dividends can create a rising source of income for a lifetime. They have proven to grow at twice the rate of inflation over the better part of stock market history.

Dividends are one of three ways for a company to return value of their profits and a portion of its free cash flow to shareholders. The other two ways are for a company to buy back its shares and to re-invest in the company.

  • A share buyback is when a company uses cash on the balance sheet to repurchase shares in the open market. This has two effects.
      • It returns cash to shareholders
      It reduces the number of shares outstanding.

    As a company increase the dividend on a annual basis, the amount may be small, but over time, it can become significant.

    For example, if you own stock in a company that pays a dividend of 57 cents per share, they may announce a dividend increase of 4 cents to 61 cents. That means you get and extra 4 cents for each share you own.

    Although, it’s only 4 cents, but 4 cents on 57 cents is am7% dividend increase on each share you own. If the dividend increased by this amount, 4 cents, every year, the dividend would double in about 10 years. Thus, over time, if you stick with dividends, the money will begin to grow.

    In S&P 500 Index companies alone paid out $485 billion in dividends to shareholders.

    Dividends outpace inflation

    Back in 1980, a $10,000 investment in the S&P 500 Index paid a dividend of about $421, or 4.21%, on the initial investment. Forty years later, the dividend income had climbed to $5,724, a 57% annual yield on the original investment. And, the original $10K investment grew as well. The original $10K invested in the S&P 500 Index in 1980 would have grown into more than $287K as the stock price increased. That’s not counting the dividends paid.

    The price-only-return (which excludes dividends income) is 8.75% per year. If you add in another 3% for the dividends you receive each year, you get a total average return of about 11.75% per year.

    Dividends have proven to be a more consistent source of growing income that has outpaced inflation.

    Dividends and Total Return over that 40 year period,

    Total return is one of the most important concepts in finance, and it involves more than just the dividends a company pays out.

    The total return of a stock is the total amount your investment changes in value, calculated by adding the amount of dividend or interest income received to the investment’s capital return (i.e. change in the investment’s price).

    Total return is driven by three components: earnings growth (which fuels capital gains and the underlying intrinsic value of a stock), dividends, and changes in valuation multiples.

    Dividends have been a major component of the stock market’s overall total returns throughout history and have contributed anywhere from 25% to 75% of the market’s overall total return over the past seven decades (the remaining portion of total return is accounted for by capital gains, or the market’s change in price).

    Takeaway, dividends are a powerful wealth building tool. If you invest in perennial dividend payers and consistent dividend grower companies, and then be patient, the dividends will add up significantly over decades.

    References:

    1. https://corporatefinanceinstitute.com/resources/knowledge/finance/dividend/
    2. https://www.wesmoss.com/news/the-power-of-investing-in-dividends-generating-income-from-stock-dividends-vs-bond-interest/
    3. https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/paying-back-your-shareholders
    4. https://1.simplysafedividends.com/dividends-vs-total-returns/

    Free Cash Flow

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    Free cash flow is the amount of leftover money in a company.

    Cash flow is simply the difference between money coming in versus the money going out. It is arguably the most important financial metric for evaluating a person’s or company’s financial worth or intrinsic value.

    Free cash flow (FCF) is the amount of cash (operating cash flow) which remains in a business after all expenditures (debts, expenses, employees, fixed assets, plant, rent etc.) have been paid. Free cash flow represents a company’s current cash value.

    Cash Flow Versus Free Cash Flow

    • Cash flow is the flow of cash coming in and going out of a business over a certain period of time. It is presented in a cash flow statement.
    • Free cash flow represents the amount of disposable cash in a business (remaining after all expenditures). Sometimes, free cash flow is considered to be a company’s current cash value. Though, since it does not take into consideration a business’s growth potential, it is not normally considered a business valuation.

    Free cash flow is the amount of cash that a company can put aside after it has paid all of its expenses at the end of an accounting period. It is an important measurement of the unconstrained cash flow of the company. It measures a company’s ability to generate internal growth and to return profits to shareholders.

    Calculation of Free Cash Flow

    FCF is simply a company’s operating cash flow (OCF) minus capital expenditures (CapEx). FCF represents how much money a company has after being free from its obligations.

    • Free cash flow = Net cash flow from operating activities – capital expenditures – dividends

    Positive free cash flow means that a company has done a good job of managing its cash. If free cash flow is negative then the company may have to look for other sources of funding such as issuing additional shares or debt financing.

    Negative free cash flow is not necessarily an indication of a bad company, however, since many young companies put a lot of their cash into investments, which diminishes their free cash flow. But if a company is spending so much cash, it should have a good reason for doing so and it should be earning a sufficiently high rate of return on its investments.

    Free cash flow can be used to expand operations, bring on additional employees or invest in additional assets, and it can be put toward acquisitions or paid out in dividends to shareholders or used to buyback company’s shares.

    References:

    1. https://strategiccfo.com/free-cash-flow-analysis/
    2. https://www.growthforce.com/blog/free-cash-flow-what-does-it-mean-for-business-growth

    Discounted Cash Flow

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    Investments are the discounted present value of all future free cash flow.

    Discounted cash flow (DCF) is a method of investment valuation in which future cash flows are discounted back to a present value using the time-value of money.

    Present value (PV) is a financial calculation that measures the worth of a future amount of money or an investment’s future cash flow in today’s dollars adjusted for interest and inflation. In other words, it compares the buying power of one future dollar to purchasing power of one today.

    PV is an indication of whether the money an investor receives today can earn a return in the future. Investors calculate the present value of a firm’s expected cash flows to decide if the stock is worth investing in today.

    An investment’s worth is equal to the present value of all projected discounted future cash flows.

    Discounted cash flow is a way of evaluating a potential investment by estimating future income streams and determining the present worth of all of those cash flows in order to compare the cost of the investment to its return.

    When an investor is trying to determine how to spend capital, it is important to determine whether or not investments will result in a positive return. The DCF method allows an investor to determine the value of the future projected cash flow in today’s dollars. An investor can subtract the amount spent on the investment from the present value of future cash flows to calculate the net present value of the investment.

    In other words, they can calculate how much money the investment will make in today’s dollars and compare it with the cost of the investment. NPV and Internal Rate of Return are the methods used in Discounted Cash Flow.

    The Net Present Value (NPV) represents the present value of cash flow. The NPV can also be called as the difference between the present values of cash inflow and cash outflow. To calculate the net present value of an investment using the discounted cash flows method:

    Example – an investor is considering investing in property that would cost his LLC $1,000,000 and he hold it for 5 years. What is the net present value of this investment using the discounted cash flows method?

    The investor determined the discount rate to be 10%. With this information, he calculated the following future discounted cash flows:

    • Year 1 = $130,000
    • Year 2 = $150,000
    • Year 3 = $200,000
    • Year 4 = $210,000
    • Year 5 = $200,000

    The total projected cash flows is $890,000.

    The net present value of this investment is $890,000-$1,000,000 which is equal to -$110,000.

    In this example, an investor should not make this investment because the original cost (cost basis) is greater than the value of the future discounted cash flow creating a negative return over the time period.

    As in this example, the DCF is compared with the initial investment. If the DCF is greater than the original cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash.

    An investor’s expected cash flows are at a discount rate that is actually the expected return. The discount rate is inversely correlated to the future cash flows. The higher the discount rate, the lower the present value of the expected cash flows.

    The NPV represents the present value of cash flow and is generally used for comparing both the internal and the external investments of a company. DCF is a method to calculate the value of an investment based on the present value of its future cash flow.

    References:

    1. https://www.myaccountingcourse.com/accounting-dictionary/discounted-cash-flow
    2. https://corporatefinanceinstitute.com/resources/knowledge/valuation/discounted-cash-flow-dcf/
    3. https://www.myaccountingcourse.com/accounting-dictionary/present-value

    Price-to-Free Cash Flow Ratio (P/FCF)

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    Free Cash Flow (FCF) – The cash left after making investments in capital assets

    The price-to-free cash flow ratio (P/FCF) is a valuation method used to compare a company’s current market share price to its per-share free cash flow.

    Free cash flow (FCF) measures a company’s financial performance. It measures how much cash a business can generate after accounting for capital expenditures such as buildings or equipment. In other words, FCF measures a company’s ability to produce what investors care most about: cash that’s available to be distributed in a discretionary way.

    FCF is calculated with the formula below:

    Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures

    Most information needed to compute a company’s FCF is on the cash flow statement. As an example, let Company A have $22 million dollars of cash from its business operations and $6.5 million dollars used for capital expenditures, net of changes in working capital. Company A’s FCF is then computed as:

    FCF = $22 – $6.5 = $15.5m

    Free cash flow relies heavily on the state of a company’s cash from operations (CFO). The cash from operations deals with the cash inflows and outflows directly related to the company’s primary activity: selling a good or service. Cash from operations is heavily influenced by the company’s net income (excluding depreciation).  

    The presence of free cash flow indicates that a company has cash to expand, develop new products, buy back stock, pay dividends, or reduce its debt. High or rising free cash flow is often a sign of a healthy and growing company that is thriving in its current environment.

    For investors, free cash flow measures a company’s ability to generate cash, which is a fundamental basis for stock pricing. This is why some people value free cash flow more than just about any other financial measure out there, including earnings per share or book value per share.

    Investors should understand that companies can manipulate their free cash flow by lengthening the time they take to pay the bills (preserving their cash), shortening the time it takes to collect what’s owed to them (accelerating the receipt of cash), and putting off buying inventory (preserving cash). Also, companies have some leeway about what items are or are not considered capital expenditures, and the investor should be aware of this when comparing the free cash flow of different companies.

    Since FCF has a direct impact on the worth of a company, investors should hunt for companies that have high or improving free cash flow but low correlated market share prices.

    Low P/FCF ratios typically can mean the shares of the underlying company are undervalued. Thus, the lower the P/FCF ratio, the “cheaper” and better value the stock remains. 

    The best, most successful investors are continually learning and continually honing and expanding their skills at making money in the financial markets.

    References:

    1. https://investinganswers.com/dictionary/p/price-free-cash-flow-ratio-pfcf
    2. https://corporatefinanceinstitute.com/resources/knowledge/valuation/what-is-free-cash-flow-fcf/
    3. https://investinganswers.com/dictionary/f/free-cash-flow