Why Is A Company's Free Cash Flow So Important?

Written By
Paul Tracy
Updated January 16, 2021

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 gains.

Question: "I've heard free cash flow is an important factor when choosing stocks, 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 will 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 stocks measure up.

Before discussing free cash flow, let's define a related term: operating cash flow. That's the amount of money left over after all expenses have been subtracted from revenue. (We give a fuller definition in our Financial Dictionary.)

Yet it's unwise to look at this number by itself.  For example, if a company generates $50 million in operating cash flow every year, but spends $100 million annually to maintain its equipment and facilities, then cash is actually flying out the door. This company is actually bleeding $50 million in cash every year, just to maintain investments in the business. (This is known as capital spending).

That's where free cash flow comes in. It takes capital spending into account, giving you a true sense of how much money is available at the end of the day.

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 of money on repairs.

Even if both companies generate the same amount of sales and operating income, you'd still want to invest in the company with better equipment and thus fewer maintenance requirements. The savings in capital spending means that company will put much more cash on its balance sheet at the end of the year.

When To Invest, When To Harvest

How much a company decides to commit to capital spending every year is a tough choice for management. If a company decides to skimp on capital spending to generate higher free cash 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 year.

You know that a company has struck the right balance when capital spending remains fairly constant, yet free cash flow is also robust. Indeed, it could be a red flag if a company suddenly stops spending on capital equipment solely to give the appearance of impressive free cash flow.

Growth Vs. Maturity

Understand that free cash flow 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 cash flow) is logical. As the company matures, capital spending should start to sharply decline, enabling free cash flow to rise higher.

Let's take automakers as an example of companies striking a balance between capital spending and free cash flow.

Ford (NYSE: F) and GM (NYSE: GM) need to spend billions of dollars a year to maintain and upgrade their key production facilities. The challenge for management is to keep that spending below the level of operating cash flow so there is enough money left over to pay down debt, buy back shares, issue dividends or simply build cash balances.

GM had a history of weak free cash flow 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 cash flow -- the best showing in years.

Executives at Ford have already grasped the importance of free cash flow. Even as Ford continues to make important investments in its business, the automaker has managed to generate roughly $5 billion in annual free cash flow over the past three years. And thanks in part to this robust free cash flow, Ford's total debt fell from $152 billion at the end of 2008 to $105 billion at the end of 2012.

With debt levels now more manageable, Ford has plans to aggressively boost its dividend in coming years, as free cash flow is returned to shareholders. 

So if you compare Ford and GM using free cash flow, Ford is the superior company. In fact, stocks like Ford are perfect for what my colleague Amy Calistri calls a "Dividend Trifecta" strategy. Simply put, it's a three-part approach to dividends that multiplies the effectiveness of every dollar you invest. The plan is specifically engineered for people who want to retire sooner or for those who would like to get a steady stream of extra income now. Go here to learn more...

Where Do I Find It?

Unfortunately, to find free cash flow, investors must do a bit of legwork.  You can always find the two important numbers you'll need -- operating cash flow and capital spending -- on a company's 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 10-K. 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.

If you simply want to get a snapshot of free cash flow, financial websites such as Yahoo Finance or MSN Money provide cash flow statements, and halfway down the page, you'll find entries for both operating cash flow and capital expenditures. Simply subtract the latter from the former.

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