What is Free Cash Flow?
Free cash flow (FCF) is a measurement of the amount of cash available to a business after necessary expenses.
A company’s Free Cash Flow can be used to make new investments into the business, pay dividends, pay down debt and more. Because of this, it is a popular valuation metric to determine the value of a business.
How to Calculate Free Cash Flow
Most simply, free cash flow is calculated by taking a company’s Cash from Operations and subtracting capital expenditures (CAPEX).
FCF can be calculated in many different ways depending on your analysis and data available. You will see many variations of FCF formulas such as:
- EBIT*(1-Tax Rate) + Depreciation + Amortization – Change in Working Capital – CAPEX:
- After-Tax Operating Profit (NOPLAT) + Depreciation + Amortization – Invested Capital:
Where invested capital is Working Capital + Fixed Assets (As seen in our calculation for Return on Invested Capital (ROIC), here)
Regardless of which formula we use, we need Intel’s Balance Sheet and Statement of Cash Flows, as seen below (click to enlarge):
Using the simple definition we can take Intel’s Net Cash from Operating Activities ($21,808) and subtract cash used for additions to property, plant and equipment ($9,625), for a Free Cash Flow of $12,183 (in millions), so $12.183 billion
How to Use Free Cash Flow
Investors want to invest in companies that are generating cash. That cash can be reinvested into the business (and compounded if the company gets a good return on its invested capital), paid to investors as a dividend, pay down debt, used for acquisitions or other uses.
Investors will typically use FCF and compare to the company’s market cap to get a Price-to-FCF Ratio.
Currently, Intel’s market cap is $163 billion, so Intel trades at a Price/FCF ratio of 13.37. Investors can compare this value to other companies and see if Intel is cheap or expensive compared to the competition.
Free Cash Flow can be volatile as unlike Net Income, large purchases are immediately factored into cash flows.
Consider if Intel spend $1 billion this year on new technology to manufacture the generation of computer chips. The costs of the new technology would slowly be factored into Net Income via depreciation, but Intel would record a $1 billion hit in Free Cash Flow. So it is important to understand why big changes occur in the measurement of free cash flow, and to look at longer term trends.
Advantages of Free Cash Flow
Many investors prefer to use Free Cash Flow instead of Net Income to determine how profitable a company really is. Net Income can be much more easily manipulated with accounting gimmicks and considers “non-core” operations like profits from investment activities, where actual cash flow from operations is harder to manipulate and gives the health of the company’s “core” business.
