Free Cash Flow (FCF) is an improved version of net profit (PAT). What is easily available in company’s financial statement is PAT. But FCF must be separately calculated by the investors.
Warren Buffett mentions Free Cash Flow as “Owners Income”. It was Buffett who made the use of Free Cash Flow popular for stock analysis.
What is the use of Free Cash Flow? FCF is used to calculate intrinsic value of a company. The method used to estimate the intrinsic value of stocks is done by using a financial model called Discounted Cash Flow (DCF).
In the calculation of intrinsic value, correct estimation of free cash flow is essential. Accurate will be the free cash flow estimation, precise will be the intrinsic value calculation.
In this article we will learn about how to estimate free cash flow of a company.
Why to estimate free cash flow?
There are cases where the company has reported a positive PAT but upon calculation its FCF came negative. Negative FCF means, its intrinsic value is zero. Let’s see how FCF is derived out of PAT…
In intrinsic value calculation, experts prefer the use of Free Cash Flow instead of PAT. Why? Because free cash flow is the real representation of actual profit of the owners.
Who are the owners of a publicly traded company? It is the shareholders. It means, if you and me want to value a stock, we must know its FCF (PAT will not work).
The above flow chart will represent the difference between Net Profit (PAT) and Free Cash Flow. In terms of formula, difference between PAT and Free Cash Flow looks like this:
Allow me to explain each of the ingredients of the Free Cash Flow formula. It will help us to see FCF in its right perspective:
1. Net Profit (PAT)
It is that income which the company has generated after adjusting all expenses. These expenses includes the mandatory depreciation and amortisation, interest and income tax payment.
There is a general perception that net profit is the profit of the owners. But in reality it is not. To keep running a business profitably, there are few strategic expenses that must be accounted.
Adjustment of all these strategic expenses gives the REAL net profit (called free cash flow or owners earnings).
2. Debt Prepayment
Companies take debt to fund its operations and Capital Expenditure (CAPEX) Plans.
It is in the interest of the company to keep their long term debts within the acceptable limits. Business experts often rate debt free companies highly.
Hence, the first logical use of PAT shall be for lowering the debt levels (if necessary).
3. Depreciation & Amortisation (D&A):
This is a non-cash expense reported in company’s income statement. They are not real expenses but a mandatory accounting adjustment as per GAAP.
It can also be understood as an adjustment done in company’s asset line to incorporate for loss in value of a fixed asset (like machinery etc) with time.
As this is a non-cash expense, hence in estimation of free cash flow, we can add this expense back to PAT. It then represents the real capital (cash) available with the company for onward use.
4. Change in Working Capital
Let’s first know about the components of working capital’s formula.
- Current Asset (CA): Total liquid assets which can be converted into cash in next one year. Example of such assets is account receivables, raw material, work in progress, finished good inventory, pre-paid liability (advance), cash etc.
- Current Liability (CL): Total liability that must be paid in next one year. Example of such liability is account payables, interest dues, income tax dues, short term debts etc.
Working Capital (WC) = CA – CL
Significance of Working Capital: We are in year 2020. Suppose a hypothetical company ABC reported $100Mn in current asset (CA) in FY2019. The company also reported an immediate obligation of $75Mn in current liability (CL).
It means, out of the available $100Mn, $75Mn is already booked to handle current liabilities for the past year 2019. Hence, what is available for year 2020 is only $25Mn.
WC ($25Mn) = CA ($100Mn) – CL ($75Mn)
This $25Mn is what we call as working capital. This is the net available fund generated by the company’s operations in year 2019, that can be used to fund the operational needs in year 2020.
Suppose there is another hypothetical company XYZ which reported $120Mn in current asset (CA) in FY2019, and $130Mn in current liability (CL). As CL is more that CA, hence its working capital will be in negative.
WC (-$10Mn) = CA ($120Mn) – CL ($130Mn)
A negative working capital means, in 2019 the company has not generated enough cash to fund its current liabilities. As a result, for 2020 the company starts with zero WC.
Moreover, in 2020 it must also ensure enough current assets to take care of current liability deficit for 2019, and to meet the forthcoming current liabilities requirement for 2020.
How change in WC (year on year), effects the company’s Free Cash Flow?
- When change in WC is positive: it is an indication that the company wants to keep more liquid assets for its forthcoming operation needs. Hence, this amount is deducted from the reported PAT.
- When change in WC is negative: it is an indication that the company wants to keep less liquid assets for its forthcoming operation needs. Hence, this amount gets added into the reported PAT.
5. New Debt
To keep the business running, a company might resort to new debt. How a company will know if it needs new debt? By looking at its current and long term capital needs.
Current needs can be judged by looking at their current liability and current asset forecasts. If there is an increase in working capital between last year and current year, then the enhanced requirement must be compensated from PAT.
If these needs are large, which cannot be taken care by company’s net profit (PAT), company will resort to new debt to make up for the deficit.
A company which is making enough net profit, and is also collecting cash fast enough from its customers, may not need new debt to fund its Operations and Capex.
6. Capital Expenditure (CAPEX)
Capex is the money which a company must spend to build & upgrade its asset base. In this process they either buy new assets for the company, or they enhance the capability of their existing assets.
Buying new asset is a part of their expansion plan. Enhancement of existing asset is a part of their modernisation plan. Expansion and modernisation is done by taking up new in-house projects.
Capital Expenditure (CAPEX) is also an expense for the company. But the way Capex is reported in financial statements is different from other expenses. Normally, expenses are reported in company’s Profit & Loss A/c. But Capex is reported in company’s cash flow statement.
If CAPEX value is not reported in cash flow report, an approximate CAPEX can also be calculated from the numbers published in P&L A/c and Balance Sheet. We can use the below formula to calculate CAPEX:
Example: Free Cash Flow Calculation
In this example, we will use an example stock Reliance Industries (RIL) and calculate its free cash flow. First we will collect the numbers from its financial statement. I’ve used the database of moneycontrol to fetch the data for RIL.
There is a reason why Warren Buffett refers Free Cash Flow as Owners Income. This is that money which is the real profit for the owners of the company.
After undertaking all necessary expenses required to operate and keep the business competitive for long term, what is left in the hands of the owners is called free cash flow.
But to calculate intrinsic value of a company, calculating only one year’s free cash flow is not enough. Warren Buffett will study at least last 10 years financial data to forecast future cash flows of a company.
I’m sure not many has the time to dig so deep into the financial statement of companies. My stock analysis worksheet can help you. It estimates future cash flows, and intrinsic value of a company based on last 10 years data.
Just copy paste the data from internet into the worksheet, and rest is done automatically by it. Give it a try…