We created this video as part of our back-to-basics effort to help readers learn and / or recap on some fundamentals. The video (c. 6 min) provides the full content with visuals and narrated flow for optimal understanding. The following are the bullet points discussed in the powerpoint video which we have reproduced below for your convenience.
FCF stands for Free Cash Flow, a metric that is widely followed like Earnings Per Share or EPS.
Free Cashflow = Operating Cashflow – Capital Expenditure or Capex
FCF is not as easily manipulated as it is derived from actual cash coming in or going out of the corporate bank accounts.
Over time, FCF should approximate Net Income, should aggregated FCF be significantly less than Net Income, then something is not right. Be careful!
FCF divided by Market Cap or Enterprise Value is a valuation methodology.
Operating Cashflow (OCF) or Cashflow from Operations is derived from Net Income.
Net Income Plus Depreciation Plus Other bits of Operating Activities that cancel out one another equals Operating Cashflow.
What is Capex? Capex is investments required to keep business going, like buying equipment or software.
But over time, aggregate capex approximates aggregate depreciation.
As such, free Cashflow represents “free cash” that can be returned to investors or debtors.
Rewriting the equations:
NI = OCF - Depreciation
FCF = OCF - Capex
Capex = Depreciation, over time
Let's put CD to represent Capex or Depreciation
Therefore,
NI = OCF - CD
FCF = OCF - CD
Hence, FCF approximates NI over timeLet’s look at FCF in the bigger scheme of things.
Activists needs businesses that can generate FCF as it takes years to effect transformation in investee companies.
Compare FCF in relation to revenue, margins, market caps vs peers.
FCF is also used in valuation.
EV / FCF is better than EV / EBITDA because EBITDA is not cashflow.
FCF Yield = FCF / Market Cap, a good valuation metric.
The higher the FCF yield, the cheaper the company is trading at.
Crux of the presentation:
Q: What if FCF Yield is very high, like 10-15% and is sustainable?
A: The company should not be listed, shareholders should take it private, enjoy the 10-15% cash pouring out of the businesses annually.
Activists look for such companies and potentially catalyze their privatizations to unlock value.To conclude, FCF is a superior metric.
FCF demonstrates the cash generation capability of the business.
Activists look for businesses that can generate FCF.
FCF is not as easily manipulated as EPS.
Over time FCF should approximate Net Income.
EV / FCF is better than EV / EBITDA.
FCF yield is a good valuation metric.
That’s it! Hope you enjoyed it!
Free Cashflow is KEY!
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This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.
