What is Free Cash Flow?
Free cash flow (FCF) equals operating cash flow minus capital expenditures. If a company generates $500 million in operating cash flow and spends $200 million on capital expenditures, its FCF is $300 million. Unlike net income, FCF strips out non-cash accounting items like depreciation and amortization, providing a clearer picture of the actual cash available to reward shareholders and fund growth.
Using FCF for Valuation
The discounted cash flow (DCF) model, one of the most fundamental valuation methods, projects future free cash flows and discounts them to present value. A company generating $100 million in annual FCF growing at 8% per year, discounted at 10%, has an intrinsic value of approximately $5 billion. The FCF yield, calculated as FCF divided by market cap, offers a quick comparison tool. An FCF yield above 5% generally indicates attractive valuation for mature companies.
Key Considerations
A single year of strong FCF can be misleading. Companies can temporarily boost FCF by delaying maintenance capital expenditures or drawing down working capital. Examine FCF trends over at least three to five years and compare capital expenditure levels to depreciation. If capex consistently falls below depreciation, the company may be underinvesting in its asset base, which will eventually erode competitive position.