Free cash flow is one of the most important indicators of a firm’s operating performance. Companies that can generate strong cash flows are widely viewed as being solvent because they can meet their obligations in due time as well as pay dividends, invest in business expansion or develop a new product. Given that the free cash flow is related to the operating cash flow, firms that record gains from their core operations simply do their job well.
Calculating a firm’s free cash flow
If you are already familiar with the free cash flow model (FCF), you know that the free cash flow considers the earnings before interest and taxes (EBIT), depreciation, amortization, changes in net working capital, and changes in capital expenditure
The net working capital is the difference between a firm’s current assets and current liabilities, and it is used to determine the firm’s ability to cover its short-term obligations. A negative or a declining working capital raises concerns about the firm’s solvency because it suggests that the firm is not collecting its receivables in due time because it has a loose collection policy with a high average collection period. Hence, a declining working capital for many quarters indicates a potential liquidity problem.
The capital expenditure (CapEx) is the difference between changes in total assets and changes in total liabilities. Note that industries like the airlines, telecom, and utilities, among others, are more capital-intensive and as such, they require a higher amount of capital to run their operations.
Let’s assume that you are an APPLE (NASDAQ: AAPL) investor, and you want to calculate the free cash flow for the period 2012 – 2016. You can find information about the depreciation, amortization, changes in the working capital and changes in the CapEx in the firm’s cash flow statement.
The first step is to deduct the interest charges for a tax rate of 40% from the EBIT. Then, add back depreciation and amortization to calculate the net income for each year. The next step is to deduct the changes in CapEx (note that we deduct increases in the Capex because the company spends money) and add the changes in the net working capital. Therefore:
Free Cash Flow = Net Income – Changes in Capex + Changes in Net Working Capital
What is the free cash flow yield?
The free cash flow yield (FCF) yield can help you determine a firm’s real value by comparing the free cash flow it generates to its size. i.e. the market cap. Naturally, you would expect that the large caps generate stronger cash flows than the mid-caps, but this is not always true.
In the example above, we need to calculate the market cap. of Apple from 2012 onwards. So, we find the historical closing prices on Dec 31 of each year and the number of shares outstanding per year. We need to be accurate in our calculations to make a proper comparison of the results. Hence:
Now, we can calculate the free cash flow yield by dividing the free cash flow over the market cap. Therefore:
So, now we know that the free cash flow that Apple generates is 6.4% of its market cap, on average. Notice that the yield decreases in the years that the free cash flow is lower due to higher capital expenditures or lower net income.
A second way to calculate the free cash flow yield is to use the enterprise value, which, in my view, is more accurate as it considers the company’s debt and cash.
Enterprise value = Market Cap + Debt – Cash
The free cash flow yield using the enterprise value is:
Again, the free cash flow is 6.4% of Apple’s enterprise value. The difference is that you have taken into account the company’s debt and cash, which, at the end of the day, determine its solvency.
A final note
The free cash flow yield is a powerful tool, mostly because it establishes the relationship between the money you put in a company compared to the returns it generates. However, it goes deeper than the net income, and it investigates if the capital expenditures are justified by fixed asset investment. For example, if a firm’s CapEx is super high, yet the asset turnover ratio does not indicate a relative intensive use of the assets, the company spends more money than the income it generates.
Also, companies that are heavily using debt to fund their operations may have a higher enterprise value than other companies with a lower debt ratio. In any case, the picture you have about the company is more accurate if you use the enterprise value rather than the market cap to calculate the FCF yield.
Finally, once you know the FCF yield of the company you are interested in, make sure to compare it with the competitive firms, or at least with the benchmark of the industry. Also, you can check the company’s dividend yield and see if the company is using its free cash flow for dividend distribution. There is nothing like a continuous stream of income and capital appreciation at the same time.