This week's question highlights an important -- yet often overlooked -- way to understand a company's value. If you take the time to assess companies by this metric, you could score steady.
Question: "I've heard free cash flow is an important when choosing , but I don't really understand what it is or why it matters. Can you help?" -- John E., Plano, Texas
Answer: You're right, John. It's quite important and stocks measure up.take only a few minutes of your time to figure out. Free cash flow can help separate high-quality companies from their peers, and it's a good way to see how your
Yet it's unwise to look at this number by itself. For example, if a company generates $50 million in operating cash flow every , but spends $100 million annually to maintain its equipment and facilities, then is actually flying out the door. This company is actually bleeding $50 million in every , just to maintain investments in the business. (This is known as spending).
That's where free capital spending into account, giving you a true sense of how much is available at the end of the day.flow comes in. It takes
Let's look at two similar companies: one that has state-of-the art manufacturing plants, and the other that has under-invested in its facilities and needs to spend a great deal ofon repairs.
When To Invest, When To Harvest
How much a company decides to commit to capital spending everyis a tough choice for management. If a company decides to skimp on capital spending to generate higher free flow now, it may find itself in a bind later on as rapidly aging equipment and buildings need to be replaced. Thankfully, most companies understand the importance of keeping their capital equipment in top condition every .
You know that a company has struck the right balance when capital spending remains fairly constant, yet freeflow is also robust. Indeed, it could be a flag if a company suddenly stops spending on capital equipment solely to give the appearance of impressive free cash flow.
Understand that freeflow is mostly useful for companies that are well established and operate in mature and slow-growing industries. If a company is relatively young and has ample growth opportunities ahead, then a high level of capital spending (and therefore negative free flow) is logical. As the company matures, capital spending should start to sharply decline, enabling free flow to rise higher.
Let's take automakers as an example of companies striking a balance between capital spending and freeflow.
Ford (NYSE: F) and GM (NYSE: GM) need to spend billions of dollars ato maintain and upgrade their key production facilities. The challenge for management is to keep that spending below the level of operating flow so there is enough left over to pay down , buy back shares, dividends or simply build balances.
GM had a history of weak freeflow in recent decades, highlighting a bad track record of inefficient capital spending. It is only now understanding how to operate more efficiently. In 2012, GM generated roughly $550 million in free flow -- the best showing in .
Executives at Ford have already grasped the importance of free debt fell from $152 billion at the end of 2008 to $105 billion at the end of 2012.flow. Even as Ford continues to make important investments in its business, the automaker has managed to generate roughly $5 billion in annual free flow over the past three . And thanks in part to this robust free flow, Ford's total
With debt levels now more manageable, Ford has plans to aggressively boost its dividend in coming , as free flow is returned to shareholders.
So if you compare Ford and GM using freeflow, Ford is the superior company.
Where Do I Find It?
Unfortunately, to find free 10-K. Look for the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations," or a similarly phrased sub-heading in the . This entire section is quite helpful in learning all of the key operating and financial trends of a company. It is definitely worth your time if you are looking to deeply research a company.flow, investors must do a bit of legwork. You can always find the two important numbers you'll need -- operating flow and capital spending -- on a company's
If you simply want to get a snapshot of freeflow, financial websites such as Yahoo Finance or MSN provide flow statements, and halfway down the page, you'll find entries for both operating flow and capital expenditures. Simply subtract the latter from the former.
Thanks for your question!