FCF margin is a valuable tool to understanding how much free cash a company can generate from its revenues. In general, a higher FCF (Free Cash Flow) margin means a company doesn’t need to spend much money to create profits and free cash. Let’s discuss the basics and uncover some deeper insights on this great stock market metric.
What is FCF (Free Cash Flow)?
Free cash flow is the amount of real cash available to a company after it pays all of its expenses (labor, manufacturing, taxes) and makes its long term capital investments (offices, stores, or factories).
FCF is different from earnings (Net Income) because earnings includes depreciation on long term investments in order to give an accurate representation of a company’s true earning power from year to year.
For example, if a company makes $1 billion in profits but spends $6 billion on a factory in the same year, the company didn’t really lose -$5 billion for the year because that factory was more of an investment, creating higher profits in the future, than a yearly operating expense.
Instead of having a lumpy earnings picture when a company makes long term capital investments, a company can depreciate the expense over the life of the asset—essentially charging it against earnings over a long period of time rather than all at once.
This makes earnings more comparable from year to year, and is why depreciation as an accounting metric can be valuable.
But, the real cash flow situation of the business was indeed -$5 billion.
To represent the real cash flow of a business, we use FCF. FCF helps us understand how much a company must spend every year to expand the business, or maintain the business, through capital intensive long term investments like factories, stores, or IT equipment.
The basic definition for FCF is generally:
FCF = Cash from operations – capital expenditures
You can find both cash from operations and capital expenditures in the cash flow statement of a company’s 10-k.
Comparing the long term FCF of a company with its growth in those free cash flows can help an investor understand how efficient a business is, and how likely the company will be able to funnel a lot of cash flow back to its shareholders (through buybacks and dividend) either now or in the future.
What is FCF Margin?
Free cash flow margin simply takes the FCF and compares it to a company’s sales (or revenue).
This is helpful in comparing the free cash situation of different companies on an apples-to-apples basis. By tying FCF to a percentage of sales, we can understand the margins profile and get context on how efficient a company is on a FCF basis. The formula is as follows:
FCF Margin = FCF / revenues
Similar to other margins ratios, the FCF margin formula returns a percentage value, with a higher number indicating a higher percentage of revenues converting to FCF (or not).
You can compare FCF margin to other commonly used margins such as:
- Gross margin (Gross Profit / Revenue)
- Operating margin (Operating Income / Revenue)
- Net margin (Net Income/ Revenue)
Generally, if a company is very capital intensive, it might have a FCF margin much lower than its Net Margin level.
On the flip side, a very capital efficient business could have a much higher FCF margin than its Net Margin, especially if it is a cash cow.
What’s a good FCF Margin?
As another general rule, a FCF margin of 10-15% is usually considered pretty good. This range sort of splits the line between a capital efficient business and a capital intensive business.
That’s not to say that all companies with low FCF margins are necessarily bad.
We’ve had plenty of highly capital intensive businesses which have performed very well in the stock market, such as Exxon Mobil during its hey-day and retailers with slim margins like Walmart or Amazon.
High FCF margin businesses tend to be preferred because the lower capital intensity usually means that it’s easier to scale a business—since it doesn’t need much capital to do so.
But the reality is that there are always other factors in play when it comes to growth, and many capital efficient businesses don’t drive huge amounts of revenues as a result of their business model, and so they have a sort of capital limited constraint on their growth just like a low FCF margin business does.
Whether a FCF margin is good or not depends on the context, the individual business, its industry, and more.
Examples of Analyzing FCF Margin: ROIC
Comparing FCF margin with another key efficiency ratio like ROIC can also help provide context on the nature of a company’s business and the capital decisions made by its management.
Like with FCF margin, investors generally like to see high ROIC companies, and they’ve tended to command a premium compared to the overall market especially in the years leading up to, and through, the turbulent year that was 2020.
I think that understanding the relationship between ROIC and FCF margin can really help investors truly grasp the usefulness and application of FCF margin in their analysis, and so we’ll discuss that next.
Before starting, here’s the basic formula for ROIC:
ROIC = NOPLAT / Invested Capital
NOPLAT = Net Operating Profit Less Adjusted Taxes, and
Invested Capital = Working Capital + Long Term Assets
When I refer to ROIC in this post, I’m referring to operating ROIC, and you can read more about this important distinction (with full definitions) here.
High ROIC vs FCF Margin = Potential Cash Cow
Both ROIC and FCF yield tend to serve as good proxies for measuring how efficient a company is with their cash.
What I’ve noticed looking at long term averages of FCF margin and ROIC is that these tend to converge close to each other. Many high margin, asset light businesses will tend to have high returns on invested capital, and vice versa.
It makes sense if you think about it.
If a company has a low FCF margin, this generally means that they need to spend more on capex in order to grow their revenues and thus, profits.
If the company needs to spend more on capex to grow, this will increase their “Invested Capital”, since PPE is included in that metric, and so with increased Invested Capital comes lower ROIC.
It also works on the flip side…
Asset-light businesses don’t need to spend much on capex to grow, and so their PPE won’t grow much from year to year and this keeps ROIC high.
Because of this relationship, many times the long term ROIC and FCF margin will be similar for a company.
But there’s times where it isn’t.
In particular you might notice that a company has a much higher ROIC than its FCF margin, and wonder how that is possible.
Rather than keep you in suspense forever, I’ll just tell you: it’s probably a cash cow.
Many times the companies with high FCF margins will have critical capital allocation decisions to make. They don’t want to waste that free cash flow on expensive projects that don’t return a lot (low ROIC), so they have a quandary.
Say you’re a CEO. If you have a pile of company cash, and there’s no good high ROIC projects to put it into, you could either:
- Waste it on low ROIC projects, and lower future ROIC
- Keep the cash on the balance sheet, which lowers ROIC
- Return the capital to shareholders
Turns out that option C takes the best of both worlds, as long as a company can maintain a sufficient growth rate over time.
When a company returns capital to shareholders, whether through a dividend or share buyback, this reduces invested capital and keeps ROIC high.
Shareholders like it too because it increases total return.
And the bonus with share buybacks is that this returning of capital increases Earnings per share, Book Value per share, Free cash flow per share, and eventually the Stock Price per share, which provides growth while still keeping ROIC high.
Of course, a company can’t just return all their cash back to shareholders, because then the free cash flow itself doesn’t grow, which can cause competitors to steal market share and eventual future earnings and cash, reducing long term ROIC.
But it needs to strike a good balance, and usually if the company is a true cash cow they can return gobs of cash back to shareholders which pushes ROIC up so much higher than its FCF margin.
I’ll give you some examples of companies with high ROIC vs their FCF margin over the last 10 years (geometric average ending 2020), and how much they reduced shares outstanding over that same time period:
- Mastercard ($MA) = 101.4% ROIC, 40% FCF Margin, -21.4% shares outstanding
- Nike ($NKE) = 28.2% ROIC, 7.9% FCF Margin, -19.4% shares outstanding
- Home Depot ($HD) = 26.6% ROIC, 8.5% FCF Margin, -35.2% shares outstanding
- Intuit ($INTU) = 43.4% ROIC, 31.0% FCF Margin, -18.8% shares outstanding
If you look at these companies’ EPS growth numbers over the same time period, you’ll see superior results against the S&P 500, and great shareholder returns alongside it. Turns out they were great cash cows after all.
Lower ROIC than FCF Margin: Potential Cash Hoarder
What about when a company has a higher FCF margin compared to its ROIC? Is it an anti-cash cow?
Remember that ROIC and FCF margin tend to work hand-in-hand with each other, and over the long term, these metrics tend to converge.
But, it all depends on the capital allocation decisions of a CEO, and these decisions can make long term ROIC much higher than FCF margin (cash cow), or much lower (not necessarily bad).
It’s not that we, as investors, want to see one metric over the other.
Rather, we should look at a company’s relationship with its ROIC and FCF margin and see if it makes sense for that particular business.
Take a company in a high growth technology industry as an example. Assuming the company doesn’t have a strong competitive advantage, it’s probably foolish for that company to act like a cash cow because:
- Technology innovation moves very fast
- Without a technological moat, this quick innovation can allow competitors to easily swoop in and steal market share (lowering growth and long term ROIC and FCF margin)
What about the opposite side of the fence, where ROIC is much lower than its FCF margin?
Well, simply, it means that they have been stockpiling cash (or working capital).
When you calculate Invested Capital for ROIC, you should be including PPE and goodwill (long term assets that require use of FCF through capex or acquisitions), and adding working capital.
We noted how these relationships between FCF and PPE/goodwill will cause ROIC and FCF margin to converge.
But in the case that working capital shrinks (through buybacks and dividends) the ROIC goes higher, and if it expands (through cash or inventories, etc), the ROIC goes lower—all else remaining equal.
We want to still see growth of free cash, revenues, etc, when ROIC changes like this—but again, as long as it makes sense for the business, then either higher ROIC or higher FCF margin can be a good thing to see.
Let’s look at a few great businesses with these characteristics (comparing their median ROIC over the last 10 years with their median FCF margin):
- Facebook (FB) = 17.7% ROIC, 33.2% FCF Margin
- Microsoft (MSFT) = 23.5% ROIC, 31.3% FCF Margin
- Visa (V) = 20.8% ROIC, 44.5% FCF Margin
- Cisco (CSCO) = 12.6% ROIC, 24.9% FCF Margin
What these companies are telling us—in their decisions to hoard capital rather than make expensive acquisitions, capex, or returning it to shareholders—is that they are biding their time for the right investment opportunities, or their stocks are too expensive for share buybacks, or both.
Maybe they see acquisition targets as too expensive, or expansion capex as wasteful… or they could simply be accumulating capital to make a huge splash soon.
As investors, you want to try and evaluate the company’s place in its industry and try to understand why they are hoarding this cash rather than returning it to shareholders, and if it’s indicative of a long term pattern, or it’s just a short term development.
FCF margin can be a valuable tool in helping to understand the capital structure of a business, especially when you combine it with other key stock market metrics.
While you should never rely on one metric to make a judgement on a business, looking at the FCF margin can help you both evaluate the business model and the decisions of management, as long as you are putting it in the proper context.
I think a broad education on all of the stock market metrics is great to help you narrow down which metrics you most want to focus on depending on what stock you are looking at.
That’s why we compiled a list of 52 of the most essential ones, which you can access for free by clicking the “Yes! Sign Me Up” button below.