Though it’s tempting to focus on a stock’s dividend payments in a world of low returns, a company’s free cash flow (FCF) could be a better metric for evaluating which stocks to hold in your retirement portfolio. Increasing free cash flow is a good sign for a company’s future earnings and share value and indicates that it can pay dividends to shareholders, in the case of dividend stocks. Decreasing free cash flow means that a company might face liquidity problems and might have to take on new debt to finance its activities.
Free cash flow – a company’s operating cash flow minus its capital expenditures – is what lets a company pursue new opportunities. Developing new products and services could increase shareholder value if they succeed. You can calculate FCF by looking for cash flow from operations or operating cash on the company’s cash flow statement, where you’ll also find its capital expenditures. Free cash flow can increase when a company increases its revenue, improves its efficiency, reduces its costs, buys back shares or pays off debt.
To understand free cash flow by comparing it with something more familiar, think about your own household. Your personal free cash flow is what’s left of your paycheck after you make your car payment or buy your subway pass, pay your rent or mortgage, buy your groceries and take care of your other obligatory monthly expenses. It’s the money you use to create a better future for yourself by investing it for retirement, putting it toward an entrepreneurial venture or making extra principal payments to get rid of your debt faster.
There are ways for companies to manipulate their activities and their financial statements to make FCF look more appealing than it really is, such as underreporting capital expenditures, manipulating accounts receivable or taking longer to pay suppliers. Still, free cash flow is considered harder to manipulate than some other performance indicators, and it’s certainly worth considering when evaluating stocks for your retirement portfolio. (For more, see Free Cash Flow: Free, but not Always Easy.)
“Retirees who own individual stocks are often looking for stability and for companies that can weather a storm in the future,” says Keith Hickerson, executive vice president and chief operating officer of the American College of Financial Services in Bryn Mawr, Pa. “The first rule of retirement investing is not to lose money, and the second rule is to maintain purchasing power and, if possible, grow that purchasing power over time through increasing dividends and capital gains. Stocks that generate a lot of free cash flow may be well positioned to help retiree investors meet both of those tests.”
Chartered financial analyst Ben Malick, founder of Three Nine Financial, a financial planning and investment management firm based in Grain Valley, Mo., says that when evaluating stocks, he cares about free cash flow, not dividends. “When a company decides to issue dividends, its managers feel that the excess capital might get better returns in the hands of shareholders than in the hands of the company,” says Malick. “This is why you typically see high-growth companies with no dividends and more mature businesses paying out dividends.... On the other hand, free cash flow is a direct indication of the health and operations of the business. If an investor can get a good handle on free cash flows, they will be able to determine how much the business is worth.”
He continues, “Dividends are paid out of free cash flow. So if a company decides to pay a dividend, they will usually examine the free cash flows to determine a prudent amount. If an investor is investing based on dividends, it is appropriate to examine how much of the free cash flow is being used to fund dividends.” By dividing the annual dividend by annual free cash flow, investors can see how much of the company’s cash generation is being returned to shareholders and how much is being reinvested in the business. If the company is paying out more in dividends than it brings in through free cash flow, that’s a red flag, according to Malick.
Hickerson adds that healthy free cash flow gives companies that do pay dividends the option to increase those dividends at a rate that maintains purchasing power for shareholders. For companies that don’t pay dividends, healthy free cash flow gives them more money to grow the business’ intrinsic value, which should increase its stock price over time.
Whether the company pays dividends or not, companies with significant free cash flow have more financial flexibility to deal with changing economic and business environments, which could reduce investor anxiety during turbulent periods. “The real winning business is the one that can both generate a lot of cash and put whatever cash is retained to work at high returns on capital,” says Hickerson.
A company’s ability to generate cash is important, because significant free cash flow gives businesses more choices in both good times and bad. As Hickerson says, it lets companies take advantage of opportunities and ensures that they will be there for investors over the long haul. (For more, see Free Cash Flow Yield: The Best Fundamental Indicator.)