Concept of Free Cash Flow

Introduction: Concept of Free Cash Flow

We have already established that it is cash and not earnings, which is important when it comes to the valuation of any company. In the previous module, we assumed that cash flow was equivalent to the dividends received by investors. This point of view was based on what seems like an obvious fact that investors pay cash in the form of stock price and receive cash only in the form of dividends. Hence, dividends are pretty much the sole source of cash inflow.

However, a little logical reasoning proves this chain of thought to be flawed. There can be other sources of receiving cash apart from dividend payments. Let’s have a look at that reasoning first.

Dividends Are Not The Only Source of Investor Compensation:

If dividends are the only source of inflow for the investor, then companies that never pay dividend should have no value at all! However, they do have value. The reason behind this is pretty simple.

Dividends only determine the time when the cash will be released to investors. Once the company has made money, it doesn’t matter if it pays dividends today or if it pays them tomorrow with interest as compensation.

Thus, if a company has created value, its share price will go up regardless of whether it is paying dividend right away or will do so at a later date. According to most experts, it is cash flow or more specifically “free cash flow” which tells us whether or not a company has created value. Let’s look at this concept of free cash flow in more detail.

The All Important “Free Cash Flow”

Many experts including Warren Buffet believe that accounting statements are not useful when it comes to valuing a company. They simple see a company as a cash processing machine.

On one hand, it guzzles cash in the form of investments whereas on the other hand, it gives out cash in the form of revenues and profits. Therefore, as long as the company can produce more cash than it consumes, it is creating value.

The cash flow situation of a company can be measures through multiple metrics. However, as investors we are concerned with two particular matrices called the free cash flow to the firm and free cash flow to equity.

Free Cash Flow To Firm:

Free cash flow to the firm, as the name suggests, is the amount of cash flow that is available to all the investors of the firm. This cash flow figure is arrived at after making multiple adjustments.

  • First, all operating expenses have to be subtracted. It is assumed that these expenses are being paid in cash
  • Then, cash is set aside for short term investments in working capital and inventory for the forthcoming cycle
  • Lastly, big capital investments, if any are made from this cash flow and hence these amounts also need to be deducted

It is important that these issues are prioritized in the order in which they have been mentioned above. At the end of all the planning and future investments, the company will be left with some cash for which it has no immediate use. This is called “Free cash flow to the firm”

On a technical note, the FCFF is available to both equity as well as debt investors. However, in reality debt investors have a preferential claim on the cash flow.

Free Cash Flow To Equity:

Now, the FCFF amount pertains to all investors in the company. However, the first right to that cash belongs to the debt holders. After financing obligations are fulfilled, it is the preference shareholders who get a claim on that money. Lastly after everyone else is paid off, the residual free cash flow belongs to the equity shareholder. This is Free Cash Flow to Equity or FCFE i.e. the second cash flow metric that is commonly used.

Free cash flow to equity is a closer proxy for dividends than free cash flow to the firm. This is because the firm pays dividends only after the other investors have been paid off.

In future articles, we will learn about both these concepts in greater details.


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