Free cash flow comes with a few caveats one need to be aware of.
Besides calculating a company's free cash flow, one need to study its cash flow statement closely to really find out what is going on.
Example: Company Property X - no free cash flow but paying dividends
Operating profits 830m
Other (operating) (648m)
Operating cash flow 182m
Tax paid -
Net cash from operations 182m
Capex (441m)
Free cash flow (259m)
Equity dividends paid (139m)
This is a property company. Making money from selling properties (assets) is a normal part of its day-to-day activities. It makes sense to consider the sales of assets a part of the free cash flow.
Free cash flow (259m)
Add back asset sales 1,358m
ADJUSTED FCF 1,099m
Equity dividends paid (139m)
This company is more than able to pay its dividends to its equity owners.
Always need to study the cash flow statements to understand what is really going on.
Example: Company Serial-Acquirer Y - lots of free cash flow but regularly buying companies
Occasionally, one comes across companies that seem to be producing lots of free cash flow when in reality they are not.
If you study the investing section of the cash flow statement more closely, large cash outflows might not be found in the capex section but can be found somewhere else, such as acquisitions.
Operating profits 46.3m
D&A 13.1m
Profits on disposals (1.6m)
Change in working capital `1.3m
Other (operating) 1.3m
Operating cash flow 57.9m
Tax paid (14.4m)
Net cash from operations 43.5m
Capex (6.9m)
Free cash flow 36.6m
Equity dividends paid (9.7m)
This is a company that keeps spending a lot of money on acquisitions regularly and yearly.
Acquisition (18m)
ADJUSTED FCF 18.6m
For this company, the cash spend on acquisitions should probably be used to calculate free cash flow, in order to give a fair picture. When this is done, its free cash flow is significantly reduced.
This company may be too reliant on buying other companies to produce the cash flow needed to pay its dividend. Before looking at this company as a potential investments, one would certainly want to investigate this further.
