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Free Cash Flow: The True Measure of Value

What is Free Cash Flow?

Free cash flow (FCF) is what Warren Buffett calls “owner earnings”. It is the amount of cash a company has left over after taking care of capital expenditures (CapEx) and working capital needs.

Why Care About Free Cash Flow?

Positive and growing free cash flow over a range of the past 5-10 years is one of the key characteristics to look for in a business when assessing long-term investment opportunities, as this is a good indication that a company benefits from one or several types of durable competitive advantage.

The advantage of achieving positive free cash flow is that there is plenty of money to cover the company’s operational needs, while having money left over that can be spent on future growth, or benefit shareholders short-term in the form of share buybacks or dividends.

While most analysts and even company management often focus on reported earnings or earnings per share (EPS), these don’t really drive value in the long-term. The major driver of value is free cash flow. This is further reflected by free cash flow being a key component when performing a discounted cash flow (DCF) analysis, which is used to determine a company’s value today based on an estimation of all estimated future free cash flows, discounted back to today with a suitable discount rate.

How to Calculate Free Cash Flow

The simplest way to calculate free cash flow is to subtract all capital expenditures from a company’s net operating cash flow. Both items are listed on the cash flow statement.

As an example, Thermo Fisher Scientific reported net operating cash flow of $8.29 billion, and capital expenditures of $1.47 billion, resulting in a free cash flow of $6.82 billion.

An easier way to find a company’s current free cash flow is to look at a company’s cash flow statement on MarketWatch.com, which lists the free cash flows for the past 5 years.

The estimation of free cash flow using the equation above is probably sufficient for us amateur investors. To get more technical, however, the calculation of free cash flow can be made quite complicated, as is described in great detail in the book Valuation, 7th Edition.

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