Quality companies turn most of their profits into free cash flow on a regular basis

We can use free cash flow as a tool for checking the quality of a company's profits.

The stock market has been littered with companies that seemed to be very profitable but turned out to be anything but.

Investors can save themselves a lot of heartache and some painful losses by taking a few minutes to study how effectively a company converts profits into free cash flow.

One of the simplest and best ways to test the quality of a company's profits and whether you think they are believable or not is to compare a company's underlying or normalised earnings with its free cash flow.   

The free cash flow will show you how much surplus cash the company has left over to pay shareholders.  It can often be very different from EPS, even though it is supposed to tell you the same thing.  For most years, you want to see the free cash flow has been close to earnings.

Calculating free cash flow

Example:  Company Z ($ m)

Net cash flow from operations  69.0

Capex -6.8

FCF to the firm (FCFF) 62.7

Minority or preference dividend paid 0.0

Interest paid -0.3

Interest received 0.0

FCF for shareholders (FCF)  62.4

Weighted average number of shares in issue  504.6m

FCF per share 12.37 sen

Underlying EPS  11.9 sen

Quality companies turn most of their profits into free cash flow on a regular basis

How quality companies generate free cash flow?

Cash flow is the lifeblood of any business.

There have been numerous companies that seemed to be very profitable, but were teetering on the edge of bankruptcy because they couldn't turn their profits into cash fast enough.

Profits and cash flow are not the same thing, and it is not sufficient for a company to be profitable to make it a good investment.

After finding out that a company is profitable, is to see how good that company is at turning its profits into cash flow.

A company's future free cash flow is the ultimate determinant of how good an investment the company will be.  Cash flow is the key determinant of its share price and the size of the dividend it will pay out to shareholders - which are the two elements that comprise the total returns from owning a share.

Free cash flow to the firm (FCFF)

Cash flows from operating activities + dividends received from joint ventures - tax paid  = net cash flow from operations

Net cash flow from operations - capex = FCFF

Free cash flow for shareholders (FCF) or Free cash flow for equity (FCFE)

FCFF - net interest (interest received - interest paid) - preference share dividends - dividends to minority shareholders = FCF

How can you use free cash flow numbers to identify good companies to invest in and bad ones to stay away from? 

A company with very little debt and a tiny interest payment, virtually all of the FCFF become FCF or FCFE.  In other words, there is not much difference between FCFF and FCF or FCFE.   This is a positive sign for investors and you should look for this sort of situation in companies you are analysing.

In contrast, a company with lots of borrowings and therefore interest bills to pay, the FCFF and FCF or FCFE will be different.   The interest payment has eaten up a big chunk of the company's FCFF, leaving less FCF or FCFE for shareholders.  In general, it is a good idea to avoid companies with lots of debt.  Too much of their FCFF can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their FCFF to repay debt and lower their future interest bills.  This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Look for a company with vey good long-term track record of producing free cash flow for its shareholders.

Companies that produce lots of free cash flow can make excellent investments.

Free cash flow to equity

From Wikipedia, the free encyclopedia

In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders. The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.

Contents

  [hide] 

• 1Basic formulae
• 2FCFF vs. FCFE
• 3Negative FCFE
• 4Uses
• 5References
• 6External links

Basic formulae[edit]

Assuming there is no preferred stock* outstanding:

${\displaystyle FCFE=FCFF+Net\ Borrowing-Interest*(1-t)}$

where:

• FCFF is the free cash flow to firm;
• Net Borrowing is the difference between debt principals paid and raised;
• Interest*(1–t) is the firm's after-tax interest expense.^[3]

or

${\displaystyle FCFE=NI+D\&A-Capex-\Delta WC+Net\ Borrowing}$

or

${\displaystyle FCFE=NI-[(1-b)(Capex-D\&A)+(1-b)(\Delta WC)]}$

where:

• NI is the firm's net income;
• D&A is the depreciation and amortisation;
• b is the debt ratio;
• Capex is the capital expenditure;
• ΔWC is the change in working capital;
• Net Borrowing is the difference between debt principals paid and raised;
• In this case, it is important not to include interest expense, as this is already figured into net income.

FCFF vs. FCFE[edit]

• Free cash flow to firm (FCFF) is the cash flow available to all the firm's providers of capital once the firm pays all operating expenses (including taxes) and expenditures needed to support the firm's productive capacity. The providers of capital include common stockholders, bondholders, preferred stockholders, and other claimholders.
• Free cash flow to equity (FCFE) is the cash flow available to the firm’s common stockholders only.
• If the firm is all-equity financed, its FCFF is equal to FCFE.

Negative FCFE[edit]

Like FCFF, the free cash flow to equity can be negative. If FCFE is negative, it is a sign that the firm will need to raise or earn new equity, not necessarily immediately. Some examples include:

• Large negative net income may result in the negative FCFE;
• Reinvestment needs, such as large capex, may overwhelm net income, which is often the case for growth companies, especially early in the life cycle.
• Large debt repayments coming due that have to be funded with equity cash flows can cause negative FCFE; highly levered firms that are trying to bring their debt ratios down can go through years of negative FCFE.
• The waves of the reinvestment process, when firms invest large amounts of cash in some years and nothing in others, can cause the FCFE to be negative in the big reinvestment years and positive in others;^[5]
• FCFF is a preferred metric for valuation when FCFE is negative or when the firm's capital structure is unstable.

Uses[edit]

There are two ways to estimate the equity value using free cash flows:

• Discounting free cash flows to firm (FCFF) at the weighted average cost of capital (WACC) yields the enterprise value. The firm’s net debt and the value of other claims are then subtracted from EV to calculate the equity value.
• If only the free cash flows to equity (FCFE) are discounted, then the relevant discount rate should be the required return on equity. This provides a more direct way of estimating equity value.
• In theory, both approaches should yield the same equity value if the inputs are consistent.

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity

*Where there are preferred shares and minority interests, the dividends paid to them must be subtracted from the FCFF to get the FCFE.

KEY INPUTS TO FREE CASH FLOW (FCF)

KEY INPUTS TO FREE CASH FLOW (FCF)

Free Cash Flow (FCF) is calculated by taking the Operating Income (EBIT) for a business, minus its Taxes, plus Depreciation & Amortization, minus the Change in Operating Working Capital, and minus the company’s Capital Expenditures for the year. This derives a much more accurate representation of the Cash that a company generates than does pure Net Income:

FCF = EBIT x (1-tax) + D&A - Changes in Working Capital - Capex

Operating Cash Flow: Better Than Net Income?

Operating Cash Flow: Better Than Net Income?
By Rick Wayman
Updated November 16, 2015 —




Operating cash flow is the lifeblood of a company and the most important barometer that investors have. Although many investors gravitate toward net income, operating cash flow is a better metric of a company's financial health for two main reasons. First, cash flow is harder to manipulate under GAAP than net income (although it can be done to a certain degree). Second, "cash is king" and a company that does not generate cash over the long term is on its deathbed.

But operating cash flow doesn't mean EBITDA (earnings before interest taxes depreciation and amortization). While EBITDA is sometimes called "cash flow", it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows.



Overview of the Statement of Cash Flows
The statement of cash flows for non-financial companies consists of three main parts:

Operating flows - The net cash generated from operations (net income and changes in working capital).
Investing flows - The net result of capital expenditures, investments, acquisitions, etc.
Financing flows - The net result of raising cash to fund the other flows or repaying debt.

By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories) and other current accounts, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important.


Accrual Accounting vs. Cash Flows
The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. A company's cash cycle is the process that converts sales (based upon accrual accounting) into cash as follows:

Cash is used to make inventory.
Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay).
Cash is received when the customer pays (which also reduces receivables).
There are many ways that cash from legitimate sales can get trapped on the balance sheet. The two most common are for customers to delay payment (resulting in a build up of receivables) and for inventory levels to rise because the product is not selling or is being returned.

For example, a company may legitimately record a $1 million sale but, because that sale allowed the customer to pay within 30 days, the $1 million in sales does not mean the company made $1 million cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the $1 million is still in accounts receivable.



Harder to Fudge Operating Cash Flows
Not only can accrual accounting give a rather provisional report of a company's profitability, but under GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits.


An example of income manipulation is called "stuffing the channel" To increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received, because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "steals" sales from the following periods (as inventories are sent back). (Note: While liberal return policies, such as consignment sales, are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.)

The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS. In this situation, investors should determine the source of the cash hemorrhage (inventories, receivables, etc.) and whether this situation is a short-term issue or long-term problem. (For more on cash flow manipulation, see Cash Flow On Steroids: Why Companies Cheat.)


Cash Exaggerations
While the operating cash flow statement is more difficult to manipulate, there are ways for companies to temporarily boost cash flows. Some of the more common techniques include: delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves).

Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but I think it is also a legitimate financing strategy. The challenge is being able to determine management's intent.



Cash Is King
A company can only live by EPS alone for a limited time. Eventually, it will need cash to pay the piper, suppliers and, most importantly, the bankers. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash. Strangely, despite all this evidence, investors are consistently hypnotized by EPS and market momentum and ignore the warning signs.



The Bottom Line
Investors can avoid a lot of bad investments if they analyze a company's operating cash flow. It's not hard to do, but you'll need to do it, because the talking heads and analysts are all too often focused on EPS.



Read more: Operating Cash Flow: Better Than Net Income? https://www.investopedia.com/articles/analyst/03/122203.asp#ixzz5CkLd7MuT
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Free Cash Flow For The Firm - FCFF

What is 'Free Cash Flow For The Firm - FCFF'

Free cash flow for the firm (FCFF) is a measure of financial performance that expresses the net amount of cash that is generated for a firm after expenses, taxes and changes in net working capital and investments are deducted. FCFF is essentially a measurement of a company's profitability after all expenses and reinvestments. It's one of the many benchmarks used to compare and analyze financial health.



BREAKING DOWN 'Free Cash Flow For The Firm - FCFF'

FCFF represents the cash available to investors after a company has paid all of its costs of doing business, invests in current assets (such as inventory) and invests in long-term assets (such as equipment). FCFF includes both bondholders and stockholders when considering the money left over for investors.

The FCFF calculation is a good representation of a company's operations and its performance. FCFF takes into account all cash inflows in the form of revenues, all cash outflows in the form of ordinary expenses and all reinvested cash needed to keep the business growing. The money left over after conducting all of these operations represents a company's FCFF.



Calculating FCFF

The calculation for FCFF can take many forms, and it's important to understand each version. The most common equation is shown as:

FCFF = net income + non-cash charges + interest x (1 - tax rate) - long-term investments - investments in working capital

Other equations include:

FCFF = Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate ) - Capex

FCFF = earnings before interest and taxes x (1 - tax rate) + depreciation - long-term investments - investments in working capital

FCFF = earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate - long-term investments - investments in working capital



Benefits of Using FCFF

Free cash flow is arguably the most important financial indicator of the value of a company's stock. The value, and therefore the price, of a stock is considered to be the summation of the company's expected future cash flows.

However, stocks are not always accurately priced. Understanding a company's FCFF allows investors to test whether a stock is fairly valued. 

FCFF also represents a company's ability

• to pay out dividends, 
• conduct share repurchases or 
• pay back debt holders. 

Any investor who is looking to invest in a company's corporate bond or public equity should check its FCFF.

A positive FCFF value would indicate that the firm has cash left after expenses.

A negative value indicates that the firm has not generated enough revenue to cover its costs and investment activities.

• In that instance, an investor should dig deeper to assess why this is happening. 
• It can be a conscious decision, as in high-growth tech companies that take consistent outside investments, or it could be a signal of financial issues.

https://www.investopedia.com/terms/f/freecashflowfirm.asp




Calculating FCFF

The calculation for FCFF can take many forms, and it's important to understand each version. The most common equation is shown as:

FCFF = net income + non-cash charges + interest x (1 - tax rate) - long-term investments - investments in working capital

Other equations include:

FCFF = Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate ) - Capex

FCFF = earnings before interest and taxes x (1 - tax rate) + depreciation - long-term investments - investments in working capital

FCFF = earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate - long-term investments - investments in working capital

Rearranging the equations:

*FCFF = [net income + interest x (1 - tax rate) + non-cash charges  - investments in working capital] - long-term investments.

Other equations include:

FCFF = [Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate )] - Capex

*FCFF = [earnings before interest and taxes x (1 - tax rate) + depreciation  - investments in working capital] - long-term investments.

FCFF = [earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate  - investments in working capital] - long-term investments

EBIT x (1-tax rate) 

= PBT x(1-tax rate) + Interest x (1-tax rate) 

= Net income + Interest x (1-tax rate)

Cash Flow from Operation 

= Net income + non-cash charges - investments in working capital

How to calculate the Free Cash Flow to Firm and Free Cash Flow to Shareholders

There are two definitions of free cash flow, both of which are useful for investors:

1.  Free cash flow to the firm (FCFF)
2.  Free cash flow for shareholders (FCF).

Free cash flow for shareholders is also referred to as free cash flow for equity.

These can be calculated very easily from a company's cash flow statement.


FCFF

To calculate FCFF, take a company's cash flows from operating activities, add dividends received from joint ventures and subtract tax paid to get the net cash flow from operations.  The subtract capex.

Net cash from operations
less Capital expenditure
add Dividends from joint ventures
= FCFF



FCF

To calculate the FCF, take the FCFF number and subtract net interest (interest received less interest paid), any preference share dividends, and dividends to minority shareholders.


FCFF
less dividends paid to minorities
less interest paid
add interest received
=FCF




When FCFF is not much different from FCF

A company with very little debt and thus, a tiny interest payment, virtually all of the free cash flow produced by the business (FCFF) becomes free cash for the shareholders (FCF).

In such a company, there is not much difference between FCFF and FCF.

This is a positive sign for investors and investors should look for this sort of situation in companies they are analysing.


When FCFF is consistently different from FCF

A company with a lot of borrowings has high interest bills to pay.

In this company, the FCFF and FCF can be consistently different for many years.

This is because the interest payments eat up a big chunk of the company's FCFF, leaving less FCF for shareholders.




Avoid companies with lots of debt

In general, it is a good idea to avoid companies with lots of debt.

• Too much of their free cash flow to the firm can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their free cash flows to repay debt and lower their future interest bills.

• This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Additional notes

Free cash flow to the firm (FCFF)

The amount of cash left over to pay lenders and shareholders.

Operating cash flow less tax and capex.


Free cash flow (FCF)

The amount of cash left over after a company has paid all its non-discretionary costs.

It is the amount of cash that the company is free to pay to shareholders in a year.

Operating cash flow less tax and capex, interest paid and preference dividends.

Calculating Intrinsic Value

Free Cash Flow of Firm

FCFF = CFO - Capex
Enterprise Value = FCFF / WACC
Enterprise Value = Equity Value + Net Debt
Equity Value = Enterprise Value - Net Debt


Free Cash Flow of Equity

FCFE = CFO - Capex + Net Debt
Equity Value = FCFE / Required rate of return on equity


Equity Value = Intrinsic Value


Investors compare this Equity Value to the Market Value in their investing.

Market Value > Equity Value = Overvalued
Market Value = Equity Value = Fair Value
Market Value < Equity Value = Undervalued



Additional Notes:

Assuming there is no preferred stock outstanding:

Interest*(1–t) is the firm's after-tax interest expense

If company has zero debt, its FCFF = FCFE