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In accounting and finance, free cash flow, or FCF, is the cash a firm produces through its operations, less the cost of expenditures on assets. Theoretically, FCF is the total amount of money that could be returned to its shareholders if no future growth is realized. There are a few competing methods for calculating free cash flow. The easiest is by examining the cash flow statement, and then pulling out the numbers for cash flow from operations and all capital expenditures (CapEx).

Another common method uses earnings before interest after taxes (EBIAT) plus any depreciation and amortization, less any working capital or current capital expenditures. There are plenty of possible distortions or objections for the most common models, so most FCF figures are assumed to be approximations.

An Estimate of Free Cash Flow

When valuing a company through cash flow analysis, all potential suppliers of capital need to be considered. Several subtleties exist that might be easily forgotten; interest is deducted before net income, for example. Financial analysts and accountants have many proposed methods of dealing with cash flow; FCF is only one such method.

Free cash flow analysis grew out of the desire to show how much cash flow exists beyond what is necessary to keep a firm operating at its current rate. Accountants soon discovered this could not be easily determined from a cursory view of the financial statements.

One way around this is to combine information from the income statement and the balance sheet to create cash flow from operating activities, or CFO. A common formula for CFO is expressed as:

Net Income + Depreciation + Amortization + Non-cash Income - Net Working Capital

Net working capital is essentially current assets less current liabilities.

Once CFO is known, the total value of all capital expenditures is subtracted. The resulting FCF number represents the amount of financial flexibility available to the firm, or the ability to make investments beyond planned future expenditures.

There is an obvious drawback to using this method; capital expenditures can vary dramatically from year to year and between different industries. This limits the use of free cash flow when assessing competing firms or performing intertemporal analysis.

For the fiscal year ended January 31, 2017, Macy's Inc. (M) recorded capital expenditures and cash flow from operating activities of $912 million and $1.801 billion, respectively.

Macy's FCF = $1.801 billion - $912 million = $889 million

The company has a large amount of FCF that it can use to pay dividends, expand its operations, and deleverage its balance sheet i.e. reduce debt.

Valuation and Free Cash Flow

On its own, FCF does not give an accurate sense of company value. Instead, future cash flow needs to be discounted to the present. After all, companies and investors expect to receive more value in the future. Most market actors are concerned about forecasted cash flows, not cash flows as they existed a short time ago.

Discounting for future cash flows is not easy. An estimated growth rate needs to be assumed and both a time interval and discounting model selected. However, having a lot of present free cash can be a good indication of possible future growth.

Value investors often look for companies with high or improving cash flows but undervalued share prices. Rising cash flow is akin to untapped potential, and the expectation is that with good business decisions, future growth is likely.

 

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