Free cash flow (fcf) valuation is one of the best tools to assess the worth of a stock. Free cash flow valuation provides investors an excellent way to evaluate the performance of a company. Professional investors consider the cash flow statement to be the ideal area to focus your attention, as it provides the most transparency of the performance the business. It is easy to calculate free cash flow from a company's cash flow statement.

Cash Flow Statement

Companies use three primary financial statements to disclose their financial performance. Unfortunately, some of these financial statements do not provide complete transparency.

The balance sheet presents the value of all assets, liabilities and equity of the company at a point in time, such as the end of the fiscal year. The term balance means that all the assets must equal the sum of the liabilities and equity. As such, it provides a snapshot of the company’s financial condition on the given date. The problem is management uses their judgment to value a number of the line items on the balance sheet. While most executives try to do the right thing, they tend to try to make the balance sheet make them look their best.

The income statement or profit and loss statement measures the money received for the sale of products and/or services is transformed into net income. The purpose of the income statement is to show if the company made or lost money during the reporting period. The problem with income statements is that some accounts depend on the accounting treatment they receive to measure the value of assets used to produce income. In addition, some accounts depend on the judgment and estimates of management subjecting them to manipulation.

The cash flow statement  measures the cash that moves into and out of a company’s bank accounts. Free cash flow measures the amount of cash a company is able to generate after paying for capital goods necessary to grow the business. As a result, the cash flow statement and free cash flow valuation are useful analytical tools to determine the performance of a company. Think of free cash flow as what the bank can put into their savings account. The cash in a bank account is more difficult for management to adjust to make them look better. This is the primary reason the cash flow statement is the choice of investors.

For investors seeking more information on how to analyze financial statements, then I suggest reading Financial Statement Analysis and Security Valuation by Stephan Penman.  By focusing on the output of financial statements, Dr. Penman helps readers understand how to use financial statements to value companies.  While expensive, this text book is an excellent reference for any investor who likes to do their own analysis and will pay for itself very quickly.

How to Calculate Free Cash Flow

For investors, cash is king. It is hard to hide financial misdeeds or problems in bank balances. These bank balances show the truth in the financial performance of a company.

Cash flow statements are comprised of three sections: Cash used and generated by operating the business. Cash used and generated from investing activities. Cash used and generated through financing activities.

Cash flow from operations includes the business activities of producing and delivering a product and/or service as well as collecting the money owed to the company for that product or service. This section of the cash flow statement measures the actual cash received for delivery of the product or service and the cash spent to create and deliver the product or service. To arrive at the operating cash flow number, you take Net Income from the Income Statement and add back changes from non-cash related accounts such as depreciation, deferred tax, amortization as well as increase/decrease in asset and liability accounts such as receivables, inventories, and payables.

In the cash flow example below, we see the comparison of Accenture Ltd (ACN) and EMC Corp (EMC) for the quarter indicated. Notice how the total cash flow from operating activities for both companies exceeds net income for the period. This is a very good sign the free cash flow valuation of each company is positive.

Cash flow from investing activities includes the business activities that the company needs to remain competitive and grow the business. This includes capital investments, acquisitions and other investments as well as sale of assets no longer needed.  For investing activities EMC is showing a cash flow of $157 million indicating they are spending on growth opportunities. A negative number is not a sign of trouble, as long as they are generating more cash than is being invested, which is the case here.

You can also quickly calculate free cash flow by subtracting cash spent for capital expenditures from operating cash flow. A positive free cash flow valuation indicates the company is generating sufficient cash to fund its growth.

Cash from financing activities includes the business activities to finance the company. Cash from investors who have bought new shares issued by the company, borrowings and payments to banks as well as dividends are some of the items that show up in this section. A negative number here is not necessarily a sign of trouble, as long as the company is able to cover these activities with the cash they are generating. In the case of EMC, they borrowed a substantial amount of money to help cover their stock repurchase program. This could be a problem, if it continues as the company is replacing stock with debt. In ACN’s case, they paid down some debt and bought back some stock using their available cash. The implication from this quarterly cash flow statement is Accenture is doing a better job generating cash than EMC. The conclusion is that ACN is a better valuation looking at just the cash flow statement. It is always a good idea to look at other quarters to see if this is a pattern or just a one time situation.

Free Cash Flow Definition

In the simplest form the free cash flow definition is where  a company receives cash for what sells and then reinvests some of that cash back into the business to grow it. To calculate free cash flow take operating cash flow from the operating cash flow segment of the cash flow statement and subtract the money spent on capital expenditures from the investing activities section of the cash flow statement.

Free cash flow may not shown on any statement, so you need to calculate it. The free cash flow example below shows that calculating free cash flow is straight forward.

Good companies generate free cash flow, meaning they have excess cash after investing in the growth of the business. This excess cash can be used to pay dividends, buy back shares, pay down debt, or saved to expand the business at a later date. Fast growing companies typically use all their excess cash to plow back into the business, so their free cash flow maybe quite small over several time periods. If free cash flow is negative, it means they are not generating enough cash from the business, so they must borrow it or issue more shares. Even for fast growing businesses, this is not a sustainable situation.

Free Cash Flow Example

The table below provides an example of a free cash flow report. In looking at their latest cash flow quarterly statements, both Accenture and EMC are good companies generating cash. However, in this example Accenture generated more free cash flow indicating they may be the preferred investment. As always, it is best to examine free cash flow over several quarters.

Using free cash flow as the only indicator would be a mistake. However, it is one of the best measures of a company’ financial performance. As a result, all investors should check out the free cash flow as one of the first factors they review before making an investment decision.

Conclusion

A company’s cash flow statement is one of the most reveling financial statements available to investors. It is an excellent place to start your investigation, as cash is king and it is more difficult to hide problem areas of a company. Free cash flow valuation measures the actual cash an ongoing company is producing.  Become a knowledgeable investor and get to know the cash flow statement of any company you like as an investment or for a trade.