Calculating Free Cash Flow is at the heart of value investing and is a key component of determining the intrinsic value of stocks, but before we get started on figuring out how to calculate it, we should define what it is. In its most basic terms:
Free Cash Flow (FCF) is the amount of cash that is left over after a company pays its bills to keep the business running.
Those bills would include staff wages, utilities, supplies, and any other operating expenses required to stay in business. Generally the more free cash flow a business has, the better off it is. Logically this makes sense because it means that the company is making more money than it needs to operate, that its products are selling well in the marketplace, and the company has its costs under control.
Now that we’re clear on the basic definition of FCF lets go through the steps to calculate it. We’ll use Apple Inc. (AAPL) in our examples since most people have heard of what the company does and are familiar with it’s products.
Step 1: Get a Hold of the Company’s Cash Flow Statement
For publicly traded companies you can get the Cash Flow Statement for free from websites like Google Finance or Yahoo! Finance, or the company’s website where investor documents like annual reports and financial statements are posted.
There’s a lot of information in the Cash Flow Statement, but the parts that you will particularly care about to calculate FCF are:
- Cash from Operating Activities
- Capital Expenditures
If we go to the Google Finance website and search for the Cash Flow Statement for AAPL you’ll find the following data for Cash from Operating Activities and Capital Expenditures for the past four years:
Step 2: Calculate Free Cash Flow
The formula for Free Cash Flow is:
FCF = (Cash from Operating Activities) – (Capital Expenditures)
In 2014 Apple generated $49.9 Billion in FCF ($59,713MM – $9,813MM). As you can see, this is a pretty simple calculation to figure out, but if you want to use FCF to calculate the intrinsic value of a stock you can’t rely on just the most recent year of FCF. Instead you’ll need to look at consistency over several years to make sure the most recent year wasn’t a fluke or something out of the ordinary.
Step 3: Look for Consistency in Free Cash Flow
Google finance shows the most recent 4 years of data in it’s financial statements which is a great start, but more data is better in this case. So going to Apple’s website and downloading historical annual reports for the last 10 years will get you the following data:
| 2014 | 2013 | 2012 | 2011 | 2010 | 2009 | 2008 | 2007 | 2006 | 2005 | |
|---|---|---|---|---|---|---|---|---|---|---|
| Cash from Operating Activities | 59,713 | 53,666 | 50,856 | 37,529 | 18,595 | 10,159 | 9,596 | 5,470 | 2,220 | 2,535 |
| Capital Expenditures | -9,813 | -9,076 | -9,402 | -7,452 | -2,121 | -1,213 | -1,199 | -986 | -657 | -260 |
| Free Cash Flow | 49,900 | 44,590 | 41,454 | 30,077 | 16,474 | 8,946 | 8,397 | 4,484 | 1,563 | 2,275 |
| % Increase Over Previous Year | 12% | 8% | 38% | 83% | 84% | 7% | 87% | 187% | -31% | 200% |
You can do the calculations for just the 4 years that Google Finance provides, but to get a better picture of consistency looking up 10 years worth of data is worth the effort to feel more confident about the company’s FCF. Calculating the percentage increase over the previous year will allow you to project future FCF growth. The formula to calculate the percentage increase over the previous year is:
% Increase = ( FCF1 – FCF0) / FCF0
In 2014 the % increase over the previous year was 12% after performing the calculation ($49,900 – $44,590) / $44,590.
FCF for AAPL has been positive all of the last 10 years which is a great sign, and it has also had a positive FCF growth rate for all but one of those years. That means that AAPL has not only managed to consistently generate free cash flow, but it has also been able to increase the amount of FCF it generates.
Step 4: Review Current Year-to-Date Performance
Having reviewed the data for the last 10 years is a great way to assess a company’s FCF paterns, but to round out your analysis you should also see how the company is performing in its current fiscal year to make sure that things are going in the same direction as the previous 10 years. The easiest way to do that is to go back to Google Finance and look up quarterly data in the Cashflow Statement.
AAPL has generated $59.961 billion in FCF through the first 3 quarters of 2015 ($67,791MM – $7,830MM). That is well above it’s previous full year resuts so at the very least we can say that AAPL’s performance for the current year is on track to match what it has delivered in it’s last 10 years.
Step 5: Confirm Your Assumptions
You could stop there since you already came up with FCF, but you should also take a moment to make sure that the assumptions you made are realistic. So you might ask the questions:
- From what is known about the company, are the assumptions that have been made to arrive at the $60+ Billion FCF realistic?
- How likely is it that the company can continue to produce those kinds of results?
The best way to answer those questions is to look through the company’s annual report. Look for a description of the product roadmap and strategy for acquiring new sales and any possible impact on costs. Are there new competitors that will be entering the market and taking a share of future profits? Are the costs of raw materials or labor projected to increase? Does the company have a stable management structure? Has the management team had a long tenure, and have their previous plans been successful?
Return on Equity is often used as a metric to measure the effectiveness of management and AAPL’s current ROE is 33.63% (above 10% is considered to be good), and its balance sheet is healthy with the company having little relative debt. Infact AAPL had no debt until 2013 which might be something to keep an eye on, however, that debt was raised in order to finance share buy backs at historically low interest rates. Since AAPL has over $231 Billion in assets the current amount of debt is not something to be concerned about, but in all stock evaluations the amount of debt is a good measuring stick to measure management’s effectiveness. Given the strong balance sheet, stable management structure, and track record for delivering consistent FCF it is a safe assumption that the company is very capable of replicating its past performance.
A Word of Caution
Past performance is not an indicator of future performance. When calculating intrinsic values you will need to project FCF for at least 10 years into the future and that is done by estimating the FCF Growth Rate. Looking at AAPL it would be tempting to select a high FCF growth rate since it has produced very high numbers in the recent past. This can happen for companies that experience periods of rapid growth, but it is not something that can be sustained over the long run. In fact, predicting growth rates of 10% or higher in the long term is not advisable and is rarely (if ever) observed. When a company becomes very large, its growth rate will come down as the sheer size of the company would make it difficult to achieve high growth rates. For those reasons the long term FCF growth rate should almost always be lower than 10%, which in itself would be a great achievement for any company to realize.
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