About Brian DeChesare
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.
Free Cash Flow in the Age of AI Hyperscalers: Time for an Update?
The traditional definition of Free Cash Flow (FCF) is Cash Flow from Operations – Capital Expenditures, and it represents a company’s “discretionary cash flow” after paying what’s required to operate and re-invest in its business and pay interest on its funding sources; recent accounting and business model changes mean that Stock-Based Compensation and Leases deserve special treatment.
Free Cash Flow Definition: The traditional definition of Free Cash Flow (FCF) is Cash Flow from Operations – Capital Expenditures, and it represents a company’s “discretionary cash flow” after paying what’s required to operate and re-invest in its business and pay interest on its funding sources; recent accounting and business model changes mean that Stock-Based Compensation and Leases deserve special treatment.
Footnotes Analyst, a site we highly recommend, recently published a feature on the AI Hyperscalers and how their huge CapEx, Lease Assets, and Stock-Based Compensation might affect the traditional definition of Free Cash Flow.
Some of the adjustments they recommend are specific to Amazon (the example company), but the TL;DR is as follows:
- To calculate FCF, start with the traditional CFO – CapEx definition.
- Then, make sure this deducts the full Lease Expense from both Operating and Finance Leases. Under IFRS, this means “deduct the Lease Principal Repayments in Cash Flow from Financing and make sure CFO properly deducts all Lease Interest.” Under U.S. GAAP, you deduct Finance Lease Principal Repayments in the same CFF section.
- Optionally, consider adding back (part of) the Cash Lease Expense and deducting the Value of New Assets Leased as the company’s “Effective CapEx,” to make for an easier comparison to companies with different leasing/ownership policies.
- And make sure you deduct the total Stock-Based Compensation, so that it is no longer a non-cash add-back in Cash Flow from Operations. SBC dilutes the existing shareholders, which makes it fundamentally different from something like Depreciation.
We agree with these recommendations except for point #3.
While there is some merit to this idea, there are better and easier ways to “normalize” companies with different leasing vs. ownership policies.
Also, in many cases, companies do not disclose enough information to execute this process, which may create consistency problems.
The proper adjustments here also depend on the purpose of your analysis.
For example, if you’re using FCF to value companies or in a deal analysis, such as in a leveraged buyout model or merger model, the Stock-Based Compensation deduction is quite important.
But if you’re running a credit analysis to determine the company’s Debt / EBITDA or EBITDA / Interest in different scenarios, this treatment matters less, and you could reflect Stock-Based Compensation by increasing its share count over time instead.
To demonstrate these concepts, we’ll walk through FCF calculations for Amazon (U.S. GAAP) and SAP (IFRS):
Files & Resources:
- Free Cash Flow: Amazon vs. SAP (XL)
- Free Cash Flow – Presentation Slides (PDF)
- Amazon – Annual Report (PDF) | Key Extracts (PDF)
- SAP – Annual Report (PDF)
Video Table of Contents:
- 0:00: Introduction
- 1:58: Short Summary
- 4:45: Part 1: What Does Free Cash Flow Mean?
- 11:05: Part 2: The Full Lease Expense
- 12:07: Part 3: Lease Additions and “Effective CapEx”
- 14:09: Part 4: Stock-Based Compensation
- 15:40: Recap and Summary
What Does Free Cash Flow Mean?
As traditionally defined, Free Cash Flow assesses a company’s ability to generate cash flow from its business, after day-to-day requirements, reinvestments, and the interest paid on its Debt and other funding sources.
This is because most of the items in Cash Flow from Operations are required for daily business (ordering inventory, collecting payments from customers, etc.).
And although the Interest Expense is not a “core-business” line item, it is required to continue operating because any company with Debt must pay interest on it.
Meanwhile, CapEx within Cash Flow from Investing is required because companies also need buildings, factories, and equipment to create and deliver products and services.
However, most other line items in Cash Flow from Investing and Financing are “optional”: Purchasing securities, making acquisitions, repurchasing stock, issuing Dividends, and even issuing and repaying Debt.
But there is a spectrum; for example, a company might be required to repay a modest percentage of its existing Debt each year, but very large repayments are typically voluntary.
When you calculate FCF under any accounting system, you should follow our Cash Flow from Operations guidelines and make sure that CFO:
- Deducts Cash Taxes.
- Reflects the Change in Working Capital.
- Reflects the Cash Net Interest Expense.
- Reverses the proper non-cash items.
- And has nothing related to CapEx, Debt, or Equity.
Once you do this, you can consider additional adjustments to the base definition.
You can also interpret Free Cash Flow.
For example, here’s Amazon’s internal version vs. our modified version:
In both cases, its FCF clearly falls over time due to dramatically higher CapEx spending on AI data centers and related infrastructure.
This is not necessarily negative because its Revenue, Net Income, and Cash Flow from Operations have all grown substantially at the same time.
So, the wisdom of this policy depends heavily on the return Amazon might realize from this elevated CapEx, which no one currently knows.
It could be “short-term pain for long-term gain,” or it could turn into a “bridge to nowhere.”
SAP shows a very different trend: It’s also a tech company, but it is spending dramatically less on CapEx (around 10% of CFO vs. over 90% for Amazon):
SAP’s Revenue, Net Income, and Cash Flow from Operations are also growing at solid rates, but it is spending vastly less on data center/infrastructure CapEx than Amazon.
SAP is not a traditional “value company,” but these different CapEx policies are very much a “growth vs. value” question.
Free Cash Flow Adjustments: The Full Lease Expense
There isn’t much to say here: The Footnotes Article is 100% correct.
Regardless of the accounting system, the full Lease Expense represents a true cash outflow used for operational purposes, so it must be deducted in FCF and all its variations, including UFCF and LFCF.
Under U.S. GAAP, you should keep the Rent deduction for the Operating Leases on the Income Statement, keep the Finance Lease Interest deduction in the same place, and either:
- Remove Finance Lease Depreciation from the normal D&A add-back; or
- Deduct the Finance Lease Principal Repayments in CFF.
Under IFRS, the points above apply to all Leases, not just Finance Leases.
IFRS-based companies often do strange things with their Interest Expense, so be careful.
For example, SAP reverses its Interest Income and Interest Expense in CFO and then records them separately in CFI and CFF:
This creates a problem because with this treatment, the Lease Interest is no longer deducted in the traditional FCF definition.
So, we “undo” their reversal to ensure that the Interest Income, Interest Expense, and Lease Interest are all reflected in FCF:
Free Cash Flow Adjustments: Lease Asset Additions and “Effective CapEx”
The Footnotes Analyst article recommends “adding back” a portion of the Operating Lease Expense, not deducting the Finance Lease Principal Repayments, and deducting the value of the New Assets Leased under both Finance and Operating Leases:
They argue that this version better represents Amazon’s FCF if it were to own all these assets directly.
Therefore, Amazon is more comparable to companies that might choose to own their assets rather than lease them.
We appreciate this argument, but we do not recommend these adjustments for several reasons.
First, it seems to create an inconsistency: Why add back only a portion of the Lease Expense?
It would be more consistent to add back the entire Operating and Finance Lease Expenses and then deduct the “Value of New Leased Assets.”
That way, it’s as if there is no ongoing cash expense for these leased assets, and only their upfront values matter.
Second, these new leased assets do not represent a cash outflow in the period.
Signing a $100-per-year lease for 10 years does not reduce a company’s cash flow by $772 today (the Present Value of this amount at a 5% Discount Rate).
And unlike Stock-Based Compensation, it does not dilute existing shareholders.
Leases are fundamentally different from both CapEx and Debt because they are much easier to cancel; companies can often pay a simple penalty fee or early termination fee to do so.
Finally, if you want to normalize companies based on owned vs. leased assets, it’s easier to use a metric such as EBITDAR (EBITDA Before Rental Expense), which is specifically designed for this.
Free Cash Flow-based metrics tend to be better for independent analysis of companies and less useful for comparisons.
Free Cash Flow Adjustments: Stock-Based Compensation
Stock-Based Compensation is not a true non-cash expense and should not be added back in any FCF metric, whether in a DCF, a deal model, or a standalone analysis.
To understand why, imagine you own a house worth $1 million and pay someone $10K per year to maintain it and make repairs.
Now, instead of paying this person $10K per year, you decide to offer him 1% of your home’s value each year.
By the end of 5 years, he would own 5% of your home, and you would own 95%.
Therefore, if you sell your home after 5 years, you’d get only $950K rather than $1 million.
This 1% annual equity grant is not “free” because it dilutes your ownership – and SBC does the same thing for companies.
So, we recommend deducting the SBC in all FCF metrics.
You could even make a case for revaluing it with Black-Scholes, but this is not necessary for a quick analysis.
In a credit analysis or standalone 3-statement model, you do not necessarily need to account for SBC like this.
You could instead keep it as a non-cash expense, but then increase the diluted share count each year to reflect the dilution:
However, you don’t always know the terms of the stock-based compensation, such as the options’ exercise price, vesting period, and expiration dates, so this approach may not be practical.
SAP presents an interesting example because it records two Stock-based Compensation components in its Cash Flow from Operations section:
We need to dig into its annual report and do some more research to explain this treatment, but it appears that they are adding back the total Stock-Based Compensation expense and then deducting the cash-settled portion.
In a case like this, we still recommend treating the entire SBC number as a normal cash operating expense, which means deducting this difference:
Free Cash Flow in the AI Age
The examples and adjustments above leave us with two main questions:
- In this age of Big Tech companies spending fortunes on AI data centers and related infrastructure and awarding employees with lavish stock-based compensation, is Free Cash Flow still a useful metric?
- If so, what does the direction of Free Cash Flow tell us about these companies?
On the first question, Free Cash Flow is still a useful metric, and we use it and its variations in valuations and deal analyses all the time.
New accounting rules and business practices require some adjustments, but the basic definition is still a good starting point.
Many of these issues are also highly industry-specific; for example, Stock-Based Compensation is a far smaller factor in sectors like transportation, oil & gas, or professional services.
The second question is harder to answer.
But using SAP and Amazon as the example companies, it comes down to this: Will Amazon’s outsized CapEx spending result in much higher revenue and profit growth in the future?
And even if its revenue and profit continue to grow impressively, would that have happened even with much lower CapEx and higher FCF?
We don’t know the answer, but we might eventually have it.
When that happens, FCF might be part of either a corporate autopsy or a corporate kingmaker ceremony.
