High Free Cash Flow (FCF)
Consistent and growing earnings are great, but they're absolutely meaningless in the absence of something else...
Because cash is real. You can see it, hold it, and watch where it goes.
Can the same be said for earnings?
Let's use the housing market as an example...
Let's say in 2001 you purchase a house for $200,000.
By 2006, the house assesses for $600,000, boosting your net worth $400,000.
You like where you live, so you don't sell. Since you don't sell, the $400,000 gain is only on paper.
Makes sense. Right? You never received $400,000 in actual cash.
However, in theory, when you choose to sell, you will have $400,000 in cash. So, you go ahead and count that $400,000 as part of your net worth.
Unfortunately, 2009 rolls around and the house once again assesses for $200,000. As a result, your net worth declines $400,000?
In reality, you didn't lose a penny. You lived in your house for eight years, and eight years later, the house is worth what you paid for it.
So how could this situation possibly cause one bit of heartache?
Well, if you counted on the $400,000 as a permanent part of your net worth, then mentally, it feels like you just lost $400,000. However, you know this isn't the case, because you never realized a real $400,000 cash gain in the first place.
But let's consider the worst case scenario...
Let's say you counted on the $400,000 as a permanent part of your net worth and you took out a home equity loan against the value of the house, using the proceeds to purchase a new Porsche, a new sailboat, and a deluxe Carnival Cruise vacation package.
If that's the case, your problem is far more serious than a mild bout with depression over lost net worth. In fact, you could face bankruptcy.
But what if you had realized a real cash gain of $400,000?
Then bankruptcy wouldn't even be an issue...
Can you see now why cash matters?
Businesses Live and Die on Cash Flow
The same standard which applies to your personal finances also applies to a business enterprise.
Why should a business be held to a different standard?
Like you, a business needs cash flow in order to survive. Without it, even the best of the best will fail.
So never waver in making the following demand of your business...
Show me the cash!
A company can have an outstanding income statement with consistently increasing earnings. But if those earnings are based on the market value of unsold inventory or unpaid accounts receivable or the skyrocketing value of real estate in Tasmania, Australia ? those earnings might be due for a fatal freefall.
Dig through the numbers and find out if there's cash flow.
Because great businesses generate cash.
Lots of cash.
If owning a great business is your goal, you want a business with tons of free cash flow...
What's Free Cash Flow?
Free Cash Flow (FCF) is the amount of money leftover after a business spends money to maintain or expand its existing business operations.
Heres the textbook definition...
Operating Cash Flow - Capital Expenditures = Free Cash Flow
In other words, if a company makes a profit of $1,000,000, but it needs to spend $800,000 to upgrade its plant and equipment just to maintain the same level of production, then the company's free cash flow is $200,000.
Why Does Free Cash Flow Matter?
High free cash flow is a sign of a strong business.
After all, what's the point of a business?
It's to generate as much cash and profit as possible. Right?
High free cash flow is a sign that this is happening.
In addition, high free cash flow enables a company to fund future endeavors without taking on a burdensome debt load.
Or, in some cases, high free cash flow opens the door for a company to take on debt, because the company can easily pay off the new debt with the mountains of cash generated by existing operations.
Even better, high free cash flow gives management the option of paying shareholders a higher quarterly dividend or the option of repurchasing shares of common stock in the open market, both of which increase value for existing shareholders.
FCF As a Measure of Business Health
Free cash flow also gives you a sense of how much a company needs to spend in order to continue its core business operations...
For example, let's say an automobile manufacturer has $1,000,000 in free cash flow. Sounds good. Right?
But what else do the numbers say?
If the auto manufacturer has $10,000,000 in operating cash flow, then you know the company required $9,000,000 in capital expenditures just to continue business operations.
And that's not out of the ordinary.
After all, the auto industry is a highly competitive business. The company needs to design new cars and trucks for the upcoming year and retool all of its assembly lines in order to produce redesigned vehicles that will measure up to those of its competitors...
Doing that takes cash.
Now, let's also say a beverage manufacturer has $1,000,000 in free cash flow.
But instead of generating $10,000,000 in operating cash flow like the auto company, the beverage company only generates $2,000,000...
Knowing this figure, you also know that capital expenditures for the beverage company are $1,000,000.
This isn't out of the ordinary either. Because while also competitive, the beverage industry doesn't perform a complete redesign of its products and manufacturing plants on an annual basis. As a result, capital expenditures aren't as high...
Well, so what?
This is what...
While both the auto company and the beverage company generate $1,000,000 in free cash flow, the beverage company only spends $1 for every dollar in cash it generates, while the auto company spends $9 for every dollar in cash it generates.
Which do you prefer?
Do you want to spend $9 to earn $1? Or do you want to spend $1 to earn $1?
Even better, let's say you only have $9 total to spend...
Would you invest your $9 in the auto company to earn $1 or the beverage company to earn $9?
You'd rather spend $9 to earn $9. Right?
Understanding the capital intensity of a business enterprise is invaluable when making an investment decision.
Generally speaking, companies with lower capital expenditure requirements are preferable to those higher capital expenditure requirements.
So when you look under the hood at a company's free cash flow, look to see how efficiently a company generates its cash.
Companies with high free cash flow and low capital expenditures make their owners very wealthy.
Your job is to find those companies and buy them...
How to Find a Company's Free Cash Flow
Buy companies with high free cash flow and low capital expenditures...
Sounds easy. Right?
But how do you find a company's free cash flow?
That's also easy if you know where to look...
Go to Yahoo! Finance and enter the ticker symbol of a company on your Stock Watch List.
In the left sidebar under the header 'Financials,' you'll find a text link titled 'Cash Flow.'
Click that link, and it takes you to a summarized version of the company's Statement of Cash Flows.
The screen displays annual figures for the last three years.
Find the most recent figure for "Total Cash Flows From Operating Activities."
This is the company's operating cash flow.
Just below that is a figure for "Capital Expenditures."
Subtract "Capital Expenditures" from "Total Cash Flows From Operating Activities," and you'll get the company's free cash flow...
Operating Cash Flow - Capital Expenditures = Free Cash Flow
It's that simple!
Now, look over the figures...
How large is the capital expenditure figure? What percentage of the operating cash flow is depleted by capital expenditures? How do those figures compare to other companies on your Stock Watch List?
Asking and answering questions like these helps you separate great companies from so-so companies on your Stock Watch List...
High Free Cash Flow = Wealth
High free cash flow is the key to wealth.
Think about it. Free cash flow basically measures how much cash ends up in your pocket versus how much cash comes out of your pocket.
And you want more cash in your pocket, right?
If so, then only buy companies with high free cash flow.
Such companies provide management with various options for rewarding shareholders.
For instance, a company with high free cash flow can pursue sensible acquisitions without incurring new debt. Or the company can buy back some of its own stock, making yours more valuable in the process. Or it can choose to raise its quarterly dividend...
Or, if it doesn't pay a quarterly dividend, it could start.
After all, companies with an abundance of cash can easily afford to pay dividends.
And dividends reward shareholders.
So that's what we're going to learn next - how to magnify your Roth IRA returns with the time-honored dividend investing strategy...
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