Heart of stock valuation: subtleties of free cash flow

Intrinsic value

No easy answers

The object of this post is to dig into to subject of free cash flow (FCF). I want to discuss some of the nuances. It’s not a GAAP or IFRS term but it is of critical importance in valuing companies today.

Understanding free cash flow basics

Free cash flow is calculated from a company’s cash flow statement. I’ve become a fan of cash flow statements. The other two statements, the balance sheet and the income statement, have diminishing relevance today.

To calculate a simple free cash flow we take the ‘cash from operating activities’ on the ‘cash flow statement’ and then subtract ‘capital expenditures’. This gives you a basic free cash flow. Many investors stop there. They shouldn’t. There’s more to it.

Getting this rough number is helpful. I get a good sense of the financial strength of the company by seeing how many years of sustainable free cash flow are needed to pay off all debt. To get to sustainable, I average back a bit and look forward. I’m happy if the company can pay off all its net debt in say four years, using free cash flow.

I can compare the free cash flow with capital expenditures to see if the company is easily able to invest in maintaining its assets and maintaining its competitive position in the marketplace. By looking the company’s recent growth rate I can assess whether the company is investing for future growth. With a simple calculation of free cash flow, I can see what room there is for further investment in growth. And if I treat the market capitalization of the company as some indication of the value of the shareholders’ equity, I can see what excess return the company is making on its equity capital. This is all rough and ready analysis.

Some nuances and subtleties

But free cash flow is also what analysts use. They calculate FCF, they forecast future FCF and discount to a present value in discounted cash flow (DCF) analysis to arrive at an estimate of intrinsic value. Since arriving at a really good estimate of value is at the heart of successful investing, we need to dig into this a little more carefully.

Let’s go back a step. To get to ‘cash from operating activities’ we start with ‘net income’ and then add back a bunch of thing. We add back depreciation, depletion and amortization which are non-cash expenses. We also add back various other non-cash items and changes in working capital. It’s here that investors need to understand what is going on. Because these add backs impact free cash flow, they have a significant impact on the DCF estimates of the fair value of a company.

Let’s look at some of these.

Stock based compensation (SBC)

Companies offer their employees stock options and other form of stock based compensation. On the income statement this compensation is expensed, i.e. it is deducted and reduces reported income even though no cash is paid. It is a non-cash item. Analysts typically add back in this item in coming up with the free cash flow number for their DCF analysis.

Consider this view: “When analysts [add back SBC] (quite common) in DCF models, that means that a typical DCF for, say, Amazon, whose stock based compensation packages enable it to attract top engineers will reflect all the benefits from having great employees but will not reflect the cost that comes in the form of inevitable and significant future dilution to current shareholders. This obviously leads to overvaluation of companies that issue a lot of SBC.” Wall Street Prep

Link to the article

Michael Mauboussin tells us that “Investors have to move the SBC figure from the “cash from operating activities” section to the “cash from financing activities” section to accurately portray the cash flow statement. A failure to do so overstates free cash flow.”

Link to the article

We can’t totally sort this out in this brief post. What is important is that investors relying on a report by an analyst using a DCF approach are not going to know how the analyst has treated SBC. The only thing we can do is be aware that some analysts might over value companies that use a lot of SBC.  

Capital leases

Companies often acquire property and equipment using capital leases. They don’t lay out the cash at the time of the acquisition. They enter into long term leases. If they were purchased outright with borrowed money, the company would record the property or equipment as assets and the debt as a liability. It would then deduct the interest expense, a financing cost, from operating income.

An accounting rules change in 2019 brought in new rules for capital leases. As Michael Mauboussin explains in the report referred to above, property and equipment acquired using capital leases is recorded “on the asset and liability sides of the balance sheet according to the new accounting standard. But the lease cost is recorded as an operating, rather than a financing, expense. The adjustment is to reclassify the embedded interest portion of the lease cost from the operating section of the income statement to the financing section.”

If the company bought the property and equipment with cash on hand, the amount paid would be subtracted from cash from operating activities on the cash flow statement on the way to calculating free cash flow. Naturally FCF is reduced dollar for dollar.

With property acquired through a capital lease one could calculate free cash flow by taking the operating cash flow and deducting all capital expenditures, purchases of assets, other net investments and then deduct principal lease payments. These principal repayments can be looked at a capital expenditures.

Alternatively, to make the calculation more comparable to an outright purchase, one might deduct all capital expenditures, purchases of assets, other net investments, as in the previous paragraph and, as well, the value of the assets acquired under the leases.

This latter approach will tend to significantly reduce free cash flow. Or, putting it another way, the use of capital leases and their current accounting treatment tends to increase calculated free cash flow. When this higher free cash flow is used in a DCF value calculation it tends to increase the fair value estimate. One might ask whether the use of capital leased to acquire property and equipment really increases the intrinsic value of companies.

Another category of property acquisition needs to be thought about. Amazon, for example, uses build-to-suit leases. These are development or construction agreements used to build out fulfillment centres. Treating them a full capex reduces FCF. Not doing so produces a higher calculated FCF and hence higher fair value estimate.

As with SBC, the investor is not to know how analysts have treated capital leases in coming up with a number for free cash flow. We just need to be aware the companies that use capital leases extensively may be leading analysts to rely on too generous numbers for free cash flow. The result might be that intrinsic value estimates are on the high side.

Capex and working capital

When we look at a growing company we are happy if the company is investing for the future. As we noted at the beginning, we calculate basic free cash flow by taking the cash from operating activities on the cash flow statement and then subtracting capital expenditures. If a company’s capital expenditures are simply maintaining the company’s position in its markets, it free cash flow may be unduly high. If it is investing heavily in future growth, free cash flow will be lower. A company investing for the future should be more valuable. But if free cash flow is lower, the DFC estimate of fair value might come out lower.

If an analyst uses the high free cash flow figure of the ‘simply maintaining’ company in a DCF calculation it may produce a high intrinsic value estimate. If they use the lower free cash flow figure of the ‘investing in future growth’ company the intrinsic value estimate will be lower. Obviously some judgement is required. Paradoxically, in the more valuable growth company free cash flow may be lower.

This leads us to the effect of changes in working capital on free cash flow calculations. We know that working capital is a measure of a company’s liquidity. It is calculated as the difference between operating current assets and operating current liabilities. We normally think that high working capital is a good thing. But, it might also indicate that inventories are too high or that the company is not investing its excess cash.

A change in working capital can increase or decrease cash from operating activities. Thus a change in working capital from one period to another can increase or decrease one’s calculation of free cash flow. An increase in working capital is a use of cash. So, it decreases free cash flow.

As with the paradox of free cash flow of companies investing for growth, there is also a paradox that companies with growing businesses will be using more working capital and will thus have lower free cash flow.

Conclusion regarding free cash flow

To paraphrase Michael Mauboussin, it all comes down to doing the proper financial statement analysis to separate the cost of running a business at a steady state from the investment a company makes to grow value. The mix between maintenance and investment spending varies based on where a company or industry is in its life cycle and management’s capital allocation choices. It’s not a simple matter. I’m not offering any easy answers.

For readers wishing to look further into DCF take a look at:

The dangers and benefits of using Discounted Cash Flow analysis reports

Stock valuation in an age of intangible assets

To read more about he shortcomings of the use of price earnings ratios to value stocks, take a look at

What is the right price earnings ratio?

Is the price earnings ratio (P/E) obsolete?


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Chapter 38. The Problem of Determining Intrinsic Value

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