Free Cash Flow
Free Cash Flow

Free Cash Flow

While we must analyze the company’s historical cash flows to understand the company’s business, when we buy a company we are not buying its historical cash flows. (Location 299)

company’s cash flows while we own it will determine how much cash, if any, we can remove from the company to reinvest or spend as we see fit. (Location 302)

By surplus and free we mean whatever cash remains after the company: 1. Uses cash to pay its operating costs such as employee salaries, wages and benefits, suppliers, utility bills, legal and accounting fees, taxes, interest on debt if any, and so forth 2. Uses cash to extend credit terms to customers and to build inventory, and 3. Uses cash to buy equipment, computers, vehicles, land, and buildings (Location 311)

Our 4x Return Multiple incorporates items (3) and (4). Our assessment of an investment’s ability to generate Free Cash Flow is our critical starting point because we are investing cash and we want to receive our return in cash. (Location 360)

We are investing cash and we expect to receive a cash return. We measure our investment’s value by its Free Cash Flow generation and so we must use a cash benchmark return. (Location 373)

will benefit from higher future Free Cash Flows because: (1) we will be able to take more cash out of the company if we want to, (2) we will have more options to grow the company by using its Free Cash Flow for new capacity or acquisitions, and (3) the higher Free Cash Flow will hopefully persuade our eventual buyer that the company’s future Free Cash Flows are likely to be higher. (Location 394)

That increase does not cover the $500,000 interest cost. If that is our best judgment, we should probably rethink a new plant. (Location 412)

Our bank’s decision to make a loan to our company assumed we would continue to be the company’s owners and our management team would stay on. (Location 417)

The debt route will often increase Free Cash Flow per share more than the equity route because with new debt we would not be issuing new common stock shares. (Location 478)

Debt interest is an incremental cost not incurred with new equity, but such interest is at least tax deductible. (Location 479)

We want to be sure our company will be able to pay the interest and principal to the lenders as required by the repayment schedule. (Location 481)

expected Free Cash Flow, the number of shares, and the amount of debt. (Location 486)

The primary purpose of accrual accounting is to hide the cash flow. (Location 512)

Remember, we are investing cash to get a cash return. Accurate accounting estimates make it difficult enough for cash flow investors to understand a company’s cash flows. Inaccurate estimates compound the challenge. (Location 535)

EBITDA is a dangerous proxy for cash flow because (1) EBITDA includes noncash items in the “Earnings” component; (2) EBITDA excludes cash required for Working Capital and (3) EBITDA excludes cash required for capital expenditures. (Location 600)

GAAP allows companies substantial latitude in choosing into which of the Cash Flow Statement’s three sections—Operating, Investing, or Financing—they put an item. (Location 611)

The flexibility companies enjoy in deciding into which of the three Cash Flow sections they put an item is one of GAAP’s biggest failings. This subject is covered in depth in Creative Cash Flow (Location 620)

interrogated management about their business, industry, competition, products and services, strengths, and weaknesses; and analyzed both the financial statements and confidential company reports. (Location 625)

Having seen the significant differences between (a) the balance sheets’ portrayal of companies’ financial condition and (b) the reality of the companies’ financial condition, here is some humble advice: Do not make investment decisions based on a company’s balance sheet or any item(s) therein other than the Cash and Marketable Securities accounts. (Location 629)

Any lender knows relying on the Current Ratio and Working Capital as liquidity proxies is very risky. (Location 640)

The less capital is tied up in operating the company, the more cash is available for more productive corporate uses and for dividends and stock buybacks. (Location 644)

but not nearly as important as how much debt falls due in each year following the balance sheet date and how much cash flow the company generates to service each year’s maturing debt. (Location 653)

The relationship between each future year’s debt service requirements (interest plus scheduled principal repayments) and expected cash flow is what counts. (Location 655)

They define Free Cash Flow as the “Cash provided by operating activities” line minus the capital expenditures number in the Investing section. This definition of Free Cash Flow results in the same Free Cash Flow number we (Location 747)

ver those five years, its (Smith Barney’s) focus on Free Cash Flow and profit margins led to a selection of stocks that happen to be sectors in demand by investors, helping to produce the nearly 108% return....” (Location 794)

Buffett tells us the value of a business is the total of the net cash flows (owners’ earnings) expected to occur over the life of the business, discounted by an appropriate interest rate.” (Location 819)

The SEC and FASB have concocted Earnings Per Share—the Government Number—to protect investors from being confused by fluctuations in cash flow. (Location 843)

The Free Cash Flow Statement is the only format that includes a cash cost margin. Comparing companies without a cash cost margin is like piloting a plane in the clouds without instruments. (Location 919)

Free Cash Flow investor approaches Revenues with a cold, objective attitude. (Location 954)

margins and/or using excessive amounts of capital. (Location 956)

If Capex is so large that it continuously results in negative Free Cash Flow—year after year—then the company is not likely to be a source of attractive long-term investor returns. (Location 958)

Always consider the two major factors that determine a company’s Revenues: unit volumes and unit prices. (Location 959)

How much of the change in Revenues from the prior period was a result of volume changes and how much was a result of price changes? (Location 962)

The smaller the company, the more important are its product and customer concentrations. Many small cap companies started out with one product and several large customers. (Location 968)

The Chief Capital Officer must manage capital utilization so the company’s investors earn an attractive return on their investment. (Location 975)

The Operating Cash Flow Margin is a revealing window into how efficiently the company is managed compared to its competitors. (Location 995)

If a company requires a relatively large amount of capital to generate additional sales, the benefit to Free Cash Flow will be muted (Location 1001)

If the same company were to focus on increasing the Operating Cash Flow Margin instead of on increasing sales, the entire benefit of the higher Operating Cash Flow Margin would increase Free Cash Flow. (Location 1002)

The Free Cash Flow Statement is not as detailed as a GAAP Income Statement, but the Free Cash Flow Statement encourages, and in fact requires, the investor to focus on what really counts. (Location 1004)

The Working Capital section is the one area where management can most easily manipulate the Free Cash Flow number, particularly in one accounting period. (Location 1026)

Free Cash Flow investors must be especially alert to manipulation of Working Capital balances because management can play these games without the approval of the company’s outside auditors. (Location 1029)

But many CEOs are clueless when it comes to finance and do not understand how unnecessary Capex (and sometimes necessary Capex) reduces investor returns below acceptable levels. (Location 1034)

An ego project is Capex that makes management feel better but results in an unnecessary decrease in Free Cash Flow and investor return. (Location 1043)

But try to determine how the company is allocating its Capex dollars—if only in a very broad-brush way—over a period of several years. (Location 1045)

Many investors do not appreciate how difficult it is to conceive, plan, and execute a major Capex project. (Location 1107)

In the book Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor, Bill Priest and Lindsay McClelland point out that “... inflation expectations drive long-term interest rates, and long-term interest rates are the discounting mechanism for future cash flows/earnings and are the driver of P/E ratios.” (Location 1146)

First, yields and interest rates act together. When interest rates go up, yields go up and vice versa. And when yields go up, stock prices go down. (Location 1157)

The 20 percent will initially decline to the extent the acquisition is financed by debt or new equity. (Location 1207)

Unfortunately, acquisitions often reduce rather than increase share value and investor returns. (Location 1215)

The best prospects are those companies that do relatively small deals and have successfully done a lot of them in their core business. (Location 1224)

It should come as no surprise that investor buybacks are funded with Free Cash Flow and/or cash and marketable securities. Debt-financed buybacks are frequently bonus buybacks or defensive buybacks. (Location 1273)

year and the investor intends to hold the stock (subject to annual review) for more than a year, then the new debt may make eminent sense. (Location 1318)

Three hurdles must be overcome to obtain our estimated investor return with McDonald’s or any company’s stock. (Location 1864)

First, our projections of McDonald’s Free Cash Flow and deployments must be essentially accurate. That’s not easy to do, stock after stock after stock, year after year after year. (Location 1865)

For example, an investor wants to find all companies with: (1) market cap over $100 million and (2) Revenue growth in last three years over 15 percent and (3) the percentile rank of the company’s annual return versus the industry return and (4) Capex as a percentage of Revenues under 10 percent. Assume the preferred screener can handle (1), (2), and (3), but not (4). (Location 2662)

Eliminate companies that have been generating negative Free Cash Flow unless a rough trend line suggests the company may soon reach positive Free Cash Flow. The last time we screened for positive Free Cash Flow only, roughly 3,600 companies survived the screen. (Location 2693)

Does this stock offer the required return (as projected in the Free Cash Flow Worksheet) appropriate to the risk (as provided in the Return Multiple)? (Location 2736)

The numerator is the Company’s incremental operating income plus depreciation and amortization, from the base period. The denominator is the weighted-average adjusted cash used for investing activities during the applicable one- or three-year period. (Location 2843)