Free cash flow is the most important metric in finance. Beyond profit, free cash is money that the company can use in many different ways to improve the position of the company. Capital allocation is one of the most important tasks a CEO faces of any company and goes a long way to increasing the value of the company. Defining those free cash flow uses and implementing them effectively is a sign of a fantastic capital allocator.
One of Warren Buffett’s secrets to his success has been his ability to allocate the free cash that Berkshire can generate every year from its operations. Buffett’s ability to allocate the free cash flow has to lead to Berkshire becoming one of the most valuable companies in the world.
Buffett thinks so much of free cash flow that he created his method of measuring that free cash flow based on the financials of a company and how he interprets the flow of money through those financials. He refers to those free cash flows as “owners’ earnings,” which means that those monies that are left over after all monies are used to operate the business area for the owners to decide how to allocate.
In today’s post, we will discuss:
- What is Free Cash Flow?
- What is the Formula for Free Cash Flow?
- What are the Five Uses of Free Cash Flow?
- Shareholder Yield: A Metric to Measure the Uses of Free Cash Flow
Ok, let’s dive in and explore free cash flow uses and their impact.
What is Free Cash Flow?
According to Investopedia:
“Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.”
Defining free cash flow can be confusing because there are different variations on the formula and what it means to different investors.
Interest payments on debt are the defining factor of what type of cash flow investors commonly refer to. By that, I mean that interest payments are generally excluded from calculations of free cash flow. The reason for this is that there are different calculations for free cash, depending on how you consider the leverage or debt of the company.
Every company has different capital structures, and some investors prefer to calculate the free cash flow differently.
The more common definition is the free cash flow to the firm, and the other, which considers leverage is the free cash flow to equity.
My goal with this post is to define the uses of free cash flow. How we can measure those uses, if you are unfamiliar with free cash flow calculations and definitions, I will provide some resources to give you a better understanding of both the calculations and reasonings behind the logic. In the next section, I will briefly cover how I like to calculate free cash flow as a reference for the rest of this post.
For now, think of free cash flow as cash available to use for things such as dividends, share repurchases, debt repayment, or reinvesting in the company.
Free cash flow analysis also offers additional benefits, such as identifying problems in the income statement.
Some investors prefer free cash flow per share as a better measure of company performance, rather than the far more basic earnings per share. Mostly for a reason that free cash flow removes items such as non-cash items from the calculations, but because the calculations for free cash flow include capital expenditures, those numbers can be uneven and lumpy over time.
An additional benefit of using free cash flow as a measure of profitability is that the calculations include working capital as a component.
The benefit of this inclusion is that it can provide an insight into the profitability and health of the business. Including working capital can provide insights into items such as accounts receivables or accounts payable, which can indicate either collections of funds quicker or the building up of inventories. All of which points you toward the profitability of a company, and items not included in the income statement.
Determining free cash flow is also valuable in the ability to determine whether a company will pay a dividend or the likelihood of the continuation of that payment. Likewise, if a company is looking to borrow funds for expansion, examining the free cash flow would provide insight into the company’s ability to repay that loan.
Ok, now that we understand free cash flow and can see some of the benefits, let’s look at one way to calculate that free cash flow.
What is the Formula for Free Cash Flow
Among the many different ways to calculate free cash flow, the one that I have settled on is the formula that I learned from Professor Damodaran. The method he uses is referred to as the free cash flow to the firm. It involves items from both the income statement and the cash flow statement. For a far better description of this process, please see below:
Let’s dive in and explore this formula a little.
The formula for free cash to the firm, according to Professor Damodaran, is this:
- EBIT (Earnings before Interest and Taxes)
- – Taxes
- + Depreciation and amortization
- (+/-) Changes in Working Capital
- – Capex
All that looks like a mouthful, but it is not that bad.
The first two items are found on the income statement, under taxes paid and operating income, or EBIT.
Let’s take at Verizon’s free cash flow, starting with the income statement.
We can see from the above income statement that we have:
- EBIT – $30,378
- Income taxes – $2,945
Now, let’s take a gander at the cash flow statement for Verizon to find our other numbers.
Ok, now we can pull out our numbers from the cash flow statement. Unfortunately, Verizon does not tell us directly what the change in working capital adds up to, so we will have to do a little math on our own.
- Depreciation and amortization expense – $16,682
- Capital Expenditures – ($17,939)
- Changes in working capital
- Accounts receivable – ($1,471)
- Inventories – ($76)
- Prepaid expenses and other ($2,807)
- Accounts Payable – ($2,359)
Calculating the changes in working capital requires us to add up the above numbers simply, and that will give us our number.
Changes in working capital = (1471) + (76) + (2807) + (2359)
Changes in working capital = (6713)
Ok, now we can calculate the free cash flow to the firm for Verizon.
FCFF = $30378 – $2,945 + $16,682 – $6,713 – $17,939
FCFF = $19,643
First, pretty easy, huh? Secondly, what the above numbers tell us is Verizon has $19,643 billion available to either pay out a dividend, repurchase shares or reinvest back into the business.
Using the above formula gives you a better idea of the actual free cash flow of a company after the operations and capital needs of the business are taken into account.
One of the downsides of a formula like free cash to the firm is that it does not work well for financials such as banks and insurance companies because those cash flows don’t flow directly to the firm because of the amount of debt and liabilities they carry because of the nature of their businesses.
Don’t worry; I will provide some ideas on how to calculate free cash for financials later in this post and is a subject for another day.
Now that we have an idea of how to determine the free cash flow of a company, let’s discuss the possible uses of those funds.
What are the Five Uses of Free Cash Flow?
Once we know how to find a company’s free cash flow, we need to determine what do we do with those funds? As the CEO of the company, we have multiple ways we can go with these funds.
The decisions we make with these funds are critical to the continued long-term success of our business, and the capital allocations we make in large part will be determined by the amount of free cash we have and how consistently the company produces those cash flows.
Let’s look at the five ways we can allocate the free cash flow.
Paying a cash dividend is one of the first most obvious choices of allocating the free cash flow.
Investors love dividends, and they are an important part of the investing process for most investors. Paying a growing dividend is also a fantastic way for a company to attract investors on a growing basis.
A company that pays a dividend indicates that it is a shareholder-friendly company because it allocates those funds back to the investor that has entrusted the company with their hard-earned money.
One reason companies pay out a dividend is the company is making enough profit to pay the dividend and use the free cash for other items such as reinvestment, debt repayments, and others.
Some of these factors must consider where the company is in its own life cycle. Typically younger companies aren’t in a position to pay dividends and use their funds to reinvest for more growth or pay down debt. As the company matures, it may choose to start to pay a dividend to attract more investors or give back to those who have stayed loyal to them over time.
Paying a dividend also is a form of discipline for the company for several reasons. Once the dividend is begun, it is incredibly important to continue down that path, because investors and Wall Street HATE it when a company cuts or stop paying a dividend. It is death to cut or stop the dividend once it is begun.
The paying of a dividend also reduces the temptation to go after riskier acquisitions or other plans as a means of growth.
Share repurchases have become over the last twenty years, one of the most popular uses of free cash flow. However, recently those choices have come under a tremendous amount of scrutiny, especially with some members of congress.
Share repurchases function as a means of returning value to shareholders in the form of more value for the shares they currently own. Once a buyback is instituted, the shareholder sees their per-share value increase with the reduction of shares available for sale.
But buybacks also benefit the company as well. Repurchasing shares can help a company reduce its cost of capital, consolidate ownership, and increase financial metrics, and, lastly, free up profits to pay executive bonuses.
It is the last two reasons from above that have lead to so much controversy regarding share repurchases; many companies, including Boeing, McDonald’s, and Caterpillar, have used repurchases as a way to line the management’s pockets.
Paying Down Debt
Paying down debt has several beneficial consequences for the company. First, as the debt is paid down over time, the interest expense will decrease, which will open up more profit for the company to use for any capital needs.
Another benefit is the ability to borrow more money if the company feels that it is a route they want to go. As the debt is paid down, it shows banks and other lenders that the company has control over its capital and will be far more likely to loan to the company again.
Reinvesting in the Company
Using the free cash flow as a means of growth for the company is probably the greatest use. Reinvesting back into the company, especially at an earlier stage of evolution of the company, is the best option.
Think of companies like Facebook, Amazon, Google, Apple, Netflix, Visa, and many others. All of these companies have done a fantastic job of creating free cash flow and reinvesting back into their companies. All of which have spurred fantastic growth for both the company and shareholders.
Metrics such as return on invested capital (ROIC), return on capital (ROC), and Enterprise multiples are wonderful ways to track the success of that reinvestment.
Buffett waxes eloquently throughout his letters to shareholders on the importance of reinvestment, and the ability to do so well as a means of growth for both the company and investor.
Buying other companies with free cash flow is another example of growth opportunities for many businesses. In fact, companies like Microsoft and Amazon have used this method to add to other components that accelerated their growth.
Many companies use cash to achieve these acquisitions, but others use their shares as a source of acquisition.
Using cash as a means of growth is common in the pharmaceutical world. Acquiring businesses that have created the latest breakthrough in pharma is one of the best ways that many businesses grow their revenues and long-term profitability. In many cases, it is far cheaper to buy another company than create the latest new drug.
Ok, now that we have identified the five ways that companies can use their free cash flow, let’s look at ways we can measure the effectiveness.
How to Measure Free Cash Flow Uses:
Shareholder yield is a metric that was first designed by William Priest in 2005. In his paper, Priest outlined shareholder yield as a metric that illustrates the way that various forms of dividends, such as dividends, share repurchases, and debt repayment return value to shareholders.
He refers to the top three ways that companies can return value in the form of dividends, or value returning actions as all essential dividends and have the same effect on us, the shareholder.
In today’s post, we will discuss the formula and an example of this in action.
The formula for shareholder yield is:
Shareholder Yield = Cash Dividends + Net Share Repurchases + Net Debt Paydown / Market Capitalization
Where dividends are going to equal dividends paid ours during the year or quarter, and share repurchases are the difference between shares issued and shares repurchased. Finally, the debt paydown is the amount paid towards reducing the amount of debt in the company.
Let’s take a look at AT&T to find the shareholder yield.
We can find all the data we need to calculate the shareholder yield from the cash flow statement.
I will pull up the 10-k from 2019 and highlight the numbers we need to calculate our yield.
Now, looking at the cash flow statement from AT&T for 2019, we can see a lot of highlighted numbers, but to calculate our yield, we need to find the net numbers.
Net debt = (27,592) + 17039 + (6904) + (276) + 4012
Net debt = 13721
Net Sharerepurchases = (2417) + 631
Net Share Repurchases = 1786
Dividends = 14888
The current market cap for AT&T is $208.4 billion, so now we can plug the numbers into the formula, and we can determine our shareholder yield.
Shareholder Yield = 14888+ 13721 + 1786 / 208.4
Shareholder Yield = 14.5%
What that number tells us is how much return shareholders receive from reinvesting the free cash flow back into the company. Many people calculate this using only the dividends and share repurchases, which, if we did that, we would have the following result.
Shareholder Yield = 14888 + 1786 / 208.4
Shareholder Yield = 7.94%
That is a pretty easy way to measure the effectiveness of the return of free cash flow is returned to shareholders using the ways that are most common such as dividends and share repurchases.
Resources for Free Cash Flow
Here are some great resources for calculating free cash flow and the uses of the free cash flow.
All of the links above are great resources to learn more about free cash flow and the different ways to calculate it based on what type of company you are analyzing, as well as some of the various ways those flows can benefit both the company and the investor.
Finally, the class by Damodaran, which is free, helps you calculate both free cash flows and how to use those flows to value a company.
All great stuff, and I highly recommend you give them a look-see. A final note, I am not being compensated in any way to recommend any of the above links, I honestly think they are the best sources of knowledge.
Free cash flow is arguably the most important metric in finance, but it is not discussed among investors as much as it should. Likely because Wall Street and analysts spend most of its time discussing earnings, revenues, and growth of the company.
While those ideas and metrics are important, what the company does with its cash flows after all of the operations are cared for is just as important to the growth of the company, as well as returning value to shareholders.
However, you determine to calculate free cash flow understand the differences, and, more importantly, how those free cash flows can be used for the company.
That is going to wrap up today’s discussion.
As always, thank you for taking the time to read this post, and I hope you find something of value for your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time.
Take care and be safe out there,