You’ll notice that I don’t shut up about this FCF stuff. The entire website is riddled with it, and there’s a good reason why. When you’re investing in a stock, you’re buying part of the business so you can get a piece of the money that company makes. While there’s lots of ways investors like to calculate how much a company earns, the only one that matters is free cash flow. This is the amount of cash that the company has left over after it pays every single conceivable expense. So if you’re an investor in a company, the money you receive from your investment will be entirely dependent on the free cash flow it produces. This free cash flow is the only thing that will end up in your pocket through a variety of ways – share buybacks, dividends, or investing in new projects. So it’s clear that the whole basis of our valuation of a company should be based on this free cash flow – if we buy a stock for cheap then we’re getting its free cash flow for cheap, if we’re buying a stock that’s expensive then we’re paying a high price for this free cash flow and that leaves us with less returns.
So now we know how important this metric is, let’s see how we calculate it.
FCF = NOPAT + (Depreciation and Amortisation) – (Capital Expenditures) – (Change in Operating Assets and Liabilities)
Click the links to learn about each item.
But even when using this formula we sometimes need to adjust things to get the true free cash flow – because this number needs to be correct, otherwise our entire valuation will be wrong and we could lose money because of it. So what we need to do is normalise the free cash flow. The easy way to do this is to simply look at the company’s FCF margin from the past 5 years. If last year was abnormally low, then calculate the average FCF from the last 5 years, and then multiply this average margin by last years sales. This will give you the normalised free cash flow of last year. Make sure that last year’s FCF wasn’t abnormally low because the company is facing a serious decline – although since were investing in company’s with a strong moat, this won’t really happen so it’s most likely just a short-term issue that depressed free cash flow.
If we want to be a bit more accurate and technical, then look at each individual part and normalise it as below.
- NOPAT = this is the operating income multiplied by (1-[tax rate]). Read the income statement from last year and make sure there aren’t any items that may be making the operating income bigger or smaller. There’s a few things to look for here, but note that the item has to be above the operating income. If it’s below the operating income then it means it hasn’t been calculated in the operating income and we can just ignore it.
- Restructuring Charges = these are one-off costs that the company took to transition or adjust their business. If this is present, simply add it to the operating income to get the true operating income.
- Impairment of Assets or Intangibles or Goodwill = this is when a company’s asset isn’t worth as much as they thought it was, so they have to decrease the value of it on their balance sheet. By accounting rules, this decrease in value has to be reported on the income statement. Note that this doesn’t mean the company actually lost all this money in cash, it’s just the way accountants compose the income statement.
- Capital Expenditures = these can vary between years, with some years having high capital expenditures and others having low. These are usually in proportion to a company’s sales, and so should be a consistent percentage of sales. So we calculate this capex as a percentage of sales for the past 10 years, and then we average the most recent 5 years. We then multiply this average percentage by last years sales, and that will give us the normalised capital expenditures for the company. Use this in calculating last year’s free cash flow.
- Change in Operating Assets and Liabilities = like capital expenditures, this number can vary significantly year-to-year. Also like capital expenditures, this should be a relatively consistent percentage of sales. So calculate this number as a percentage of sales for the last 10 years. Then average the most recent 5 years to get your average percentage. Then multiple this percentage by last years sales, and that should give you the normalised change in operating assets and liabilities for this company. Use this in calculating last year’s free cash flow.