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Free Cash Flow Definition & Calculation for Evaluating Stocks

By Kurtis Hemmerling

cash flow faucetWith thousands of dividend-paying blue chip stocks in the market, how can you figure out which ones are wise investments? Do you know what to look for to judge whether or not a company can sustain dividends?

When it comes to high-growth companies that don’t pay dividends, can you determine if their growth strategy is exceeding their budgets?

One smart method for evaluating the health of a dividend-paying company or a growth stock is to analyze its free cash flow.

Importance of Cash Flow

Most investors turn to earnings per share (EPS) to determine a company’s profitability. Earnings information is easy to find; in fact, it’s probably the most widely reported number for public companies. But it’s not the same as cash. What’s the difference, and why should you care?

Companies record earnings after making a sale. But the payment from the customer may be on credit, so the cash may not really come into the business’s hands for months or even years. The company still runs the risk of not getting the cash, in the case of extreme events like customers who default. While the company can immediately report the sale as earnings, if they don’t have access to the cash, they can’t put it to use.

While earnings are a worthwhile accounting measure, it’s hard currency that really keeps a company going. Earnings represent operational efficiency and long-term potential, but cash flow represents the value of your investment. In many cases, companies produce phenomenal earnings, but quickly declare bankruptcy due to cash flow issues.

Businesses Need Free Cash Flow

Operational cash flow is the real money that comes in from normal daily business operations. You can get this figure by working backwards from earnings:

  • Operational cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes

But this calculation has a few problems: It does not take capital expenditures into account, and it ignores the dividend payments that directly impact the amount of cash the company has on hand to fuel future growth and cover short-term expenses.

For instance, let’s say a company aggressively expands its assets by making capital investments in new machinery and a fleet of vehicles. This spending would not have an effect on operating cash flow, since it’s part of the business’s normal daily operations. Therefore, you need an equation that adjusts operational cash flow to account for the need to purchase new assets. And that’s where the free cash flow metric comes in handy. Free cash flow is the amount of cash left over from operating activities once you remove capital expenditures:

  • Free cash flow = Operational cash flow – Capital expenditures – Dividends

Free cash flow provides a clear understanding of what money is left over after a company purchases assets and distributes its dividend payments. Consider an example that shows just how different free cash flow and earnings are.

Free Cash Flow Analysis vs. Earnings Example

An innovative new company decides to market a fancy new widget. This new widget costs very little to make and has great potential to make the firm a lot of money. So the company invests heavily in production and marketing. They build new warehouses and purchase new retail outlets. But the new stores and warehouses are in downtown Manhattan, so the capital expenditures for these buildings are very high, despite little depreciation because the location is very desirable.

The widgets fly off the shelves and the company enjoys some great earnings. But the earnings don’t take into account the high cost of expansion and the huge price tag associated with the downtown property. Despite earnings growth, the company quickly runs out of money to expand its operations. Without earnings growth, share prices fall dramatically, and the company starts running into financial troubles to cover the expansion costs. As a result, the company has to issue new debt bonds or equity shares, causing further damage to the firm and its stock value.

How could the company have discovered the potential trouble earlier? Free cash flow analysis would have quickly revealed that the company was getting into an unsustainable practice of spending. In three months, the company operations expenses would look like:

  • Sales (50% credit and 50% in cash): $100 million
  • Cost of goods sold (materials and labor): $50 million
  • Depreciation: $1 million
  • New asset purchases: $50 million

The quarter’s earnings look like an astounding $49 million. But the picture cast by free cash flow is much gloomier. Since half of the sales are on credit, they only have $50 million immediately available in cash. And since direct costs of goods sold add up to $50 million, the company won’t have any cash left after covering expenses. The $50 million of new assets was money the company didn’t yet have!

Despite the rosy picture from high-growth earnings, the lack of free cash flow is a serious problem that will eventually lead to lackluster growth or the need to raise cash in ways that will hurt share prices. Eventually, the company may go into bankruptcy.

Analyzing Free Cash Flow in Stocks

Take a look at a real-world example: Brookfield Properties (NYSE: BPO). They own, develop, and operate commercial property in North America and Australia. They also develop residential land. Their earnings growth looks outstanding:

  • One-year earnings growth: 407%
  • Three-year earnings growth: 78.8%
  • Five-year earnings growth: 51.6%

Judging by earnings, the stock price should be skyrocketing, but it isn’t. While share prices may have surged this past year by almost 40%, largely due to the stock market recovery, the share price is still down more than 26% from 2006. Looking at free cash flow could have helped BPO spot the problem in time to avoid it. In fact, as early as 2004 and 2005, the problem started to become clear:

  • 2004 operational cash flow: $459 million
  • 2005 operational cash flow: $230 million
  • 2006 operational cash flow: $66 million

Investors should have hit the panic button as soon as cash flow started to drop, but that didn’t mean that all was lost. Operational cash flow decreased but remained positive, so the company could still have a good future in store. Capital expenditures will provide more information:

  • 2004 capital expenditures: $81 million
  • 2005 capital expenditures: $179 million
  • 2006 capital expenditures: $159 million

Subtracting capital expenditures from operational cash flows, BPO had $378 million (roughly $1.08 per share) of remaining cash flow in 2004, $51 million (15 cents per share) in 2005, and negative $93 million (-27 cents per share) in 2006. Clearly the company was running into cash flow problems, but despite the cash flow trouble, Brookfield continued to pay large dividends:

  • 2004 dividend payout: $94.8 million ($0.27/share dividends x 351 million shares)
  • 2005 dividend payout: $149.7 million ($0.43/share dividends x 348.15 million shares)
  • 2006 dividend payout: $174.3 million (derived from $0.50/share dividends x 348.6 million shares)

Any accountant or investor knows that you cannot continue to pay out cash you do not have. After depleting cash reserves, a final look at free cash flow sums up how evident the problems were:

  • 2004 free cash flow: $280.8 million ($0.80/share dividends x 351 million shares)
  • 2005 free cash flow: -$95.5 million (-$0.28/share dividends x 348.15 million shares)
  • 2006 free cash flow: -$261.5 million (-$0.75/share dividends x 348.6 million shares)

Sure enough, in 2006 Brookfield created a bunch of new funds to bring in over $5 billion dollars of new capital. But because it did not change its spending habits, free cash flow remained a problem after the company quickly burned through this additional capital. How did free cash flow per share continue from 2007 until 2010?

  • 2007 free cash flow: -$692.8 million(-$1.75 per share x 395.9 million shares)
  • 2008 free cash flow: -$337.4 million (-$0.86 per share x 392.3 million shares)
  • 2009 free cash flow: -$232.6 million (-$0.54 per share x 430.7 million shares)
  • 2010 free cash flow: -$612.2 million (-$1.22 per share x 501.8 million shares)

BPO has had to raise more money by issuing new shares and diluting existing shareholder ownership. In 2006, there were roughly 348 million shares outstanding; by 2010 there were over 500 million. That’s a dilution of almost 44%. Unless the company can improve its free cash flow, the struggles will continue. Especially in the presence of high capital expenditures and dividends, earnings numbers just don’t show the full picture.

Final Word

Which is better: earnings or free cash flow? Now that you know how to use each piece of data, you need to track both numbers to make the smartest moves. Earnings information provides a nice summary of a company’s day-to-day operations and long-term sustainability, and the calculation uses a more gradual reduction of capital expenditures using depreciation of assets. Free cash flow, on the other hand, represents the hard money brought in from operations minus the purchase of assets and dividends paid out.

Free cash flow can alert you to the potential dangers that may result from a lack of liquidity. Looking at the positive or negative movement of a company’s reported free cash flow will help you figure out if it has the necessary funds to finance capital expenditures and keep paying dividends.

If you invest in a blue chip stock with consistently falling free cash flow, be on the alert that dividends will decline or disappear. But if the company is new and enjoying high growth, you may want to wait out a period of negative free cash flow to see if the company can turn things around.

Do you use earnings data as well as free cash flow reports in evaluating a stock? How important do you find each number to be?

(photo credit: Shutterstock)

Kurtis Hemmerling
Kurtis Hemmerling is a personal finance enthusiast that has been putting his passion into writing since 1998. His goal is to demystify the investment world to benefit the readership of Money Crashers.

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