Why do Investors Look at Free Cash Flow(FCF)?

Key Points

• Cash Flow is a phrase commonly used by investors. There is an entire cash flow statement along with an income statement and balance sheet statement to help capture the financial health of a company for analysts and investors. 

• Cash Flow and in this particular instance Free Cash Flow(FCF) can take on several different variations when it comes to defining this metric and represents one of many Discounted Cash Flow Models(DCF). 

• Free Cash Flow is effectively the ACTUAL cash profit that a company generates and is a representation of what a company can return to shareholders.

• FCF is one of several metrics to look at when researching a stock. Companies that generate and grow strong free cash flow are typically some of the most investable for our strategies at GenVest

What FCF Tells Investors

FCF gives insight into how well run a company is financially and informs investors on the cash produced that can be allocated in the best interest of the company. Companies with robust FCF will be able to decide on future ventures directly improving shareholder value. 

This could include dividend increases, share buybacks, business expansion, or even short-term investments.

FCF in many ways gives a snapshot of how efficiently a company generates cash and whether or not they will also be able to pay off creditors. You may have heard before how XYZ company has a cash flow problem and debt obligations coming due. 

This does not mean investors will not consider a company that is highly innovative and growing top line revenue above the average market rate, but it will most certainly be flagged in their research report to keep an eye on as it will hold more risk.

There are several variations of FCF models but in its most basic sense it captures cash generated using the below formula.

FCF= Operating Cash Flow-Capital Expenditures

GenVest QuickTake

Learning how to build Cash Flow models can be time consuming for investors who are not in the financial industry but there are several courses at one’s disposal online to help learn this skill if desired. 

As a successful professional wanting to invest and secure your financial future, GenVest feels it is most important to understand why Free Cash Flow (FCF) needs to be taken into consideration as a variable when making your investment decisions.

Luckily, the internet remains one of the greatest sources by which to become informed and to discover the information you need.  Making sure it is a credible source is important but if an investor wants to know if XYZ company has strong FCF, chances are an equity research analyst for a credible group has evaluated this and broken it down for you for the sake of saving time. 

Furthermore, there are organizations such as Moody’s who give credit ratings on companies and their analysis will be directly correlated to a company’s ability to generate FCF in order to pay off debt.

Growing revenue and net income is important and has the ability to increase the value of common stock for a company, but FCF for many investors and analysts is where the true financial health of a company lies.