Free cash flow

Free cash flow (FCF) measures how much money a company makes after deducting maintenance capex, but before capex on expansion.

This is important as it allows valuation of the existing business without the harder to asses value of investment in expansion and new ventures. The latter should be worth more than the money that is being invested in them. How much more is hard to assess and valuing companies using their free cash flow sidesteps the question.

This means that using free cash flow based valuations will undervalue companies which have particularly good opportunities to invest. It will also mean that it will overvalue companies which are sufficiently badly run to make investments that destroy shareholder value. The latter is not as uncommon as it should be because managers usually benefit by expanding more than is in the best interests of shareholders.

The free cash flow is the same as what the dividends would be if a company decided to pay out as much as it could in dividends without either running down its operations or increasing debt.

Free cash flow (FCF) is often used in discounted cash flow valuations.

A rough free cash flow can be calculated from the cash flow statement:

FCF = operating cash flow - tax - capex

This free cash flow number would be used in a DCF. Free cash flow can also be used in valuation ratios. Comparing it to EV is probably the most generally useful: EV/FCF. An equity investor may prefer to also subtract net interest paid and use that number in a DCF, or to calculate cashflow per share.

The problem with this rough free cash flow is that it includes all capex, not just maintenance capex (the amount required to keep existing operations going). This is not serious problem when using a DCF provided that the forecasts used in the DCF reflect the benefits of the extra investment. It can badly distort EV/FCF and cashflow/share for companies that are investing heavily. It is usually a reasonable approach as maintenance and expansionary capex are not easily separable and expansion may be a necessity in order to stay in business, rather than being genuinely discretionary.

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