What is Free Cash Flow (FCF) in Finance?

What is Free Cash Flow (FCF) in Finance?

Introduction

When valuing assets, such as stocks, there are many different valuation multiples to use.

My favorite ways of determining if a company is good or not:

  • Earnings
  • Debt
  • Free cash flow (FCF)

Here are some useful multiples to use for stock valuation:

  • P/E
  • P/S
  • P/B
  • EV/EBIT
  • EV/E

In this blog post, I will discuss free cash flow and the formula for calculating it.

What is the Free Cash Flow in finance?

The free cash flow in a firm is the available cash that is available after deducting operating expenses.

You can compare free cash flow as the amount of money you have in your finances once all bills have been paid.

Interest payments are generally not deducted in the free cash flow calculation.

Free cash flow is also usually calculated on a per-share basis. This is because if a company issues new shares, it will dilute the current owners.

How is free cash flow used?

Free cash flow is used in the firm to pay dividends, invest in the company, or reduce its negative balance sheet.

Why should you use free cash flow for valuation?

A growing amount of cash flow usually leads to higher earnings downs the road.

Free cash flows show that the company can create earnings.

The company can use this free cash flow to invest in the business, pay off debt or perhaps pay out dividends to its shareholders.

On the other hand, if you see that the cash flow is being reduced, it might mean that the company is having trouble keeping the current earnings.

A very high free cash can mean that the company is not adequately investing in the business.

Free cash flow yield

Free cash flow yield = Free cash flow per share / Market price per share

Free cash flow to equity (FCFE)

Free cash flow to equity (FCFE) is calculated using the following formula:

Cash from operations – Capital expenditures (CAPEX) + Net debt

What is the free cash flow formula?

The free cash flow formula is as follows:

FCF = Cash from Operations – Capital expenditures

Conclusion

My personal opinion is that free cash flow is one of the best ways of measuring a company’s health.

Much as in your finances, you want as much money over after paying your bills.

Do you use free cash flow when doing the stock valuation? Please leave a comment below!

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