Free cash flow (FCF) represents the cash a company generates after accounting for the money needed to maintain and expand its operations. It is the cash available for shareholders - the fuel that can power dividends, buybacks, debt reduction, or future growth. Many investors consider FCF the most important measure of a company's financial health.
What is Free Cash Flow?
Free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures. This is real money the company can use however it chooses.
The Simple Formula: Free Cash Flow = Operating Cash Flow - Capital Expenditures
Why Free Cash Flow Matters
FCF matters because it represents actual cash, not accounting profits. Here is why investors focus on it:
- Harder to Manipulate: Earnings can be adjusted through accounting choices, but cash is concrete
- Shows Real Profitability: A company can report profits while burning cash - FCF reveals the truth
- Funds Shareholder Returns: Dividends and buybacks come from free cash flow
- Indicates Financial Flexibility: More FCF means more options for growth, acquisitions, or debt reduction
- Drives Long-term Value: Stock prices ultimately follow cash flow over time
Calculating Free Cash Flow
Basic FCF Formula
FCF = Operating Cash Flow - Capital Expenditures
Both numbers come from the cash flow statement.
Example Calculation
Company XYZ reports:
- Operating Cash Flow: $5 billion
- Capital Expenditures: $1.5 billion
- Free Cash Flow: $3.5 billion
This company has $3.5 billion available for dividends, buybacks, acquisitions, or debt repayment.
Alternative FCF Calculation
You can also calculate FCF from the income statement:
FCF = Net Income + Depreciation - Change in Working Capital - Capital Expenditures
This formula shows how earnings convert to cash after accounting for non-cash charges, working capital needs, and reinvestment.
Types of Free Cash Flow
Free Cash Flow to the Firm (FCFF)
Cash available to all capital providers (equity and debt holders).
FCFF = Operating Cash Flow - Capital Expenditures
This is the standard FCF most investors reference.
Free Cash Flow to Equity (FCFE)
Cash available specifically to equity shareholders after debt payments.
FCFE = FCFF - Interest Payments - Net Debt Repayment
Use FCFE when evaluating what is actually available for dividends and buybacks.
Key Free Cash Flow Metrics
Free Cash Flow Yield
Similar to dividend yield, but based on all available cash.
Formula: (Free Cash Flow / Market Cap) x 100
Example: A company with $3.5 billion FCF and $70 billion market cap has FCF yield of 5%.
Higher FCF yield may indicate undervaluation. Compare to:
- 10-year Treasury yield
- Industry peers
- Company's historical range
FCF Per Share
Free cash flow allocated to each share.
Formula: Free Cash Flow / Shares Outstanding
Example: $3.5 billion FCF / 1 billion shares = $3.50 FCF per share
Compare FCF per share to EPS - if FCF per share is higher, earnings quality is strong.
FCF Margin
Free cash flow as a percentage of revenue.
Formula: (Free Cash Flow / Revenue) x 100
Example: $3.5 billion FCF / $50 billion revenue = 7% FCF margin
Higher margins indicate efficient cash generation.
FCF Conversion Rate
How much net income converts to free cash flow.
Formula: Free Cash Flow / Net Income
Example: $3.5 billion FCF / $4 billion net income = 87.5%
Above 80% is generally good. Below 50% consistently may indicate earnings quality issues.
What Good FCF Looks Like
Positive Signs
- Consistently Positive: FCF positive most years, even during downturns
- Growing Over Time: FCF increasing faster than revenue indicates improving efficiency
- FCF Exceeds Net Income: Strong earnings quality
- Sustainable Dividends: Dividend payout ratio below 75% of FCF
- Balance Sheet Improvement: Using FCF to reduce debt
Red Flags
- Consistently Negative FCF: Company burns cash even in good years
- FCF Much Lower Than Earnings: Profits not converting to cash
- Dividends Exceeding FCF: Borrowing to pay dividends is unsustainable
- Volatile FCF: Unpredictable cash generation makes planning difficult
- CapEx Growing Faster Than Revenue: Becoming less efficient
FCF in Different Business Models
Capital-Light Businesses
Software, services, and digital companies often have:
- Low capital expenditure requirements
- High FCF margins (20-40%)
- FCF closely tracking net income
Capital-Intensive Businesses
Manufacturing, utilities, and telecom often have:
- High ongoing CapEx requirements
- Lower FCF margins (5-15%)
- Significant gap between earnings and FCF
Compare FCF metrics to industry peers, not across different sectors.
Using FCF for Valuation
Price to Free Cash Flow (P/FCF)
Similar to P/E but using free cash flow instead of earnings.
Formula: Stock Price / FCF Per Share
Or: Market Cap / Free Cash Flow
Example: Stock at $70 with $3.50 FCF per share = P/FCF of 20
Lower P/FCF may indicate better value. Compare to P/E - if P/FCF is lower, cash generation is strong relative to earnings.
Discounted Cash Flow (DCF)
The most detailed valuation method projects future free cash flows and discounts them to present value.
Basic concept:
- Estimate future FCF for 5-10 years
- Calculate terminal value for years beyond
- Discount all future cash to present value
- Sum equals intrinsic value of the company
Track Cash Flow Performance
Pro Trader Dashboard helps you monitor investments in companies with strong free cash flow generation.
FCF vs Other Metrics
FCF vs Earnings
- Earnings include non-cash items like depreciation
- Earnings do not reflect capital investment needs
- FCF shows actual cash available after all needs met
FCF vs Operating Cash Flow
- Operating cash flow does not subtract capital expenditures
- A company needs to invest to maintain business - FCF accounts for this
- FCF is what is actually discretionary
FCF vs EBITDA
- EBITDA ignores capital expenditures entirely
- EBITDA ignores working capital changes
- FCF is more conservative and realistic
Summary
Free cash flow represents the cash a company generates after maintaining and expanding operations. Calculated as operating cash flow minus capital expenditures, FCF shows what is truly available for shareholders. Key metrics include FCF yield, FCF per share, FCF margin, and conversion rate. Look for consistently positive and growing FCF, with high conversion from earnings. Be cautious of negative FCF, dividends exceeding FCF, or earnings far exceeding cash generation. Compare FCF metrics to industry peers and use P/FCF as a valuation check alongside P/E.
Learn more: cash flow statement guide, return on equity, and fundamental analysis basics.