Free Cash Flow

Definition

Free cash flow (FCF) is the cash generated by a company after accounting for capital expenditures needed to maintain or expand its asset base. It is a crucial metric used to evaluate a company's financial health, as it indicates the amount of cash available for distribution to investors, such as shareholders and debtholders, or for reinvestment in the business. Understanding free cash flow helps in estimating future cash flows, calculating terminal value, constructing discounted cash flow models, and analyzing dividend policies.

5 Must Know Facts For Your Next Test

1. Free cash flow is calculated by taking operating cash flow and subtracting capital expenditures.
2. Positive free cash flow indicates that a company has enough cash to pursue new opportunities or pay dividends to shareholders.
3. Negative free cash flow might signal financial distress or heavy investment in growth projects that could lead to future profitability.
4. Free cash flow is often used in valuation models to estimate the intrinsic value of a company.
5. Investors often look at free cash flow as a sign of a company's ability to generate shareholder value over time.

Review Questions

• How is free cash flow estimated and why is it important for financial analysis?
  • Free cash flow is estimated by subtracting capital expenditures from operating cash flow. This measure is important because it reflects the actual cash available for distribution to investors after maintaining or expanding the company's asset base. By analyzing free cash flow, investors can assess a company's ability to generate surplus cash for dividends, debt repayments, or reinvestment opportunities, making it a key indicator of financial health.
• Discuss how free cash flow is used in terminal value calculations within discounted cash flow models.
  • In discounted cash flow models, free cash flow plays a critical role in determining terminal value, which represents the expected future cash flows beyond a specific forecast period. Terminal value is often calculated using either the perpetuity growth model or the exit multiple approach. Both methods rely on projecting free cash flows into the future, which are then discounted back to present value to estimate the overall worth of the business. This connection emphasizes how crucial accurate free cash flow estimations are for valid valuations.
• Evaluate how changes in free cash flow influence dividend policy decisions within corporations.
  • Changes in free cash flow directly impact corporate dividend policy decisions as they reflect the amount of discretionary cash available for dividends. When a company generates strong positive free cash flow, it may increase dividend payouts to reward shareholders, reflecting confidence in its financial stability. Conversely, if free cash flow declines due to high capital expenditures or reduced operating performance, companies may choose to cut dividends or suspend them altogether. This relationship underscores the significance of monitoring free cash flow trends when assessing a company's commitment to returning value to shareholders.

Related terms

Capital Expenditures:

Expenses incurred by a company to acquire, upgrade, and maintain physical assets such as property, plants, and equipment.

Discounted Cash Flow (DCF): A valuation method that estimates the value of an investment based on its expected future cash flows, adjusted for the time value of money.

Net Present Value (NPV):

The difference between the present value of cash inflows and outflows over a period of time, used to assess the profitability of an investment.