What is Free Cash Flow? Full Explanation and Tutorial (21:49)

You’ll learn what “Free Cash Flow” (FCF) means, why it’s such an important metric when analyzing and valuing companies.

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What is Free Cash Flow? Full Explanation and Tutorial (21:49)

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You’ll learn what “Free Cash Flow” (FCF) means, why it’s such an important metric when analyzing and valuing companies.

You’ll also learn how to interpret positive vs. negative FCF, and what different numbers over time mean — using a comparison between Wal-Mart, Amazon, and Salesforce as our example.

Table of Contents:

  • 0:54 – What Free Cash Flow (FCF) is and Why It’s Important
  • 2:26 – What Positive FCF Tells You, and What to Do With It
  • 3:56 – What Negative FCF Tells You, and What to Do With It
  • 4:38 – Why You Exclude Most Investing and Financing Activities in the FCF Calculation
  • 7:55 – How to Use and Interpret FCF When Analyzing Companies
  • 11:58 – Wal-Mart vs. Amazon vs. Salesforce: Free Cash Flow Across Sectors
  • 19:33 – Recap and Summary

What is Free Cash Flow?

Normally it’s defined as Cash Flow from Operations minus Capital Expenditures.

Tells you the company’s DISCRETIONARY cash flow – after paying for expenses and working capital requirements like inventory and capital expenditures, how much cash flow can it put to use for other purposes?

If the company generates a lot of Free Cash Flow, it has many options:
hire more employees, spend more on working capital, invest in CapEx, invest in other securities, repay debt, issue dividends or repurchase shares, or even acquire other companies.

If FCF is negative, you need to dig in and see if it’s a one-time issue or recurring problem, and then figure out why: Are sales declining? Are expenses too high? Is the company spending too much on CapEx?

If FCF is consistently negative, the company might have to raise debt or equity eventually, or it might have to restructure itself or cut costs in some other way.

Why Do You Exclude Most Investing and Financing Activities Other Than CapEx?

Because all other activities are, for the most part, “optional” and non-recurring.

A normal company does not NEED to buy stocks or issue dividends or repurchase shares… those are all optional uses of cash.

All it NEEDS to do to keep its business running is sell products to customers, pay for expenses, and keep investing in longer-term assets such as buildings and equipment (PP&E).

Debt repayment and interest expense are “borderline” because some variations of Free Cash Flow will include them, others will exclude them, and some will include interest expense but not debt principal repayment.

How Do You Use Free Cash Flow?

It’s used in a DCF (or at least, a variation of it) to value a company; it’s also used in a leveraged buyout (LBO) model to determine how much debt a company can repay.

And you can calculate it on a standalone basis for use when comparing different companies.

The key is to DIG IN and see why Free Cash Flow is changing the way it is – Organic sales growth? Artificial cost-cutting? Accounting gimmicks? Different working capital policies?

IDEALLY, FCF will be increasing because of higher units sales and/or higher market share, and/or higher margins due to economies of scale.

Less Good: FCF is growing due to cost-cutting, CapEx slashing, or FCF is growing in spite of falling sales and profits… because of a company playing games with Working Capital, non-core activities, or CapEx spending.

Wal-Mart vs. Amazon vs. Salesforce Comparison

Main takeaway here is that Wal-Mart’s FCF is all over the place, but Cash Flow from Operations is MOSTLY growing, so that appears to be driven by the also growing organic sales.

The company is doing some odd things with CapEx and Working Capital, which led to fluctuations in FCF – not exactly “bad” or “good,” just neutral and requires more research.

With Amazon, they’ve increased CapEx spending massively in the past 2 years so that has pushed down CapEx. CFO is growing, driven by organic revenue growth (no “games” with Working Capital), but it’s very difficult to assess whether all that CapEx spending will pay off in the long-term.

With Salesforce, FCF is definitely growing organically (Revenue growth leads directly to CFO growth, and CapEx varies a bit but not as much as with Amazon), but the company is also spending a ton on acquisitions… will it continue?

If CapEx as a % of revenue stays low, it will most likely continue to spend on acquisitions – unlikely to issue dividends, repurchase shares, etc. since it’s a growth company.