Understanding free cash flows

Free cash flows can be thought of as the cash flows available for distribution to the shareholders. It need not necessarily be paid to the shareholders; it just shows the true picture of liquidity and the cash, which is readily available with the company that can be distributed to shareholders. In that sense, it is different from dividends. Also, unlike dividends, the free cash flows data is usually not readily available. An investor needs to calculate it, which requires a clear understanding to interpret the data correctly. However, sometimes, a company might highlight its free cash flows in the earnings call.  

Types of free cash flows  

There are two types of free cash flows: Free cash flows to the firm (FCFF) and free cash flows to the equity (FCFE). FCFF is the cash flow available to all the company’s stakeholders after paying all the operating expenses as well as making the necessary investments in working capital (e.g., inventory) & fixed capital (e.g., machinery).  

Meanwhile, FCFE is the cash flow available to the company’s common shareholders after all the operating expenses, interest & principal payments have been made along with making all the required investments in working capital & fixed capital. 

Formula  

FCFF= Cash flow from operations (CFO) + interest*(1-tax rate) +/- fixed capital investment. 

FCFE= FCFF – interest (1- tax rate) +/- net borrowings  

FCFF can be derived using net income or even operating profit. Understanding it through CFO is relatively easier.  

Why is it important?  

Free cash flows are mainly used for the valuation of a particular stock, to see whether the stock price really reflects the true business efficiency. If a company is not paying adequate dividends, the FCF method is the best to use to estimate the intrinsic value of the stock of a company. A healthy and steady FCF is what an investor should look for in the company. However, a company boasting about how strong its financial position is, which has a decreasing trend in free cash flows, might not be the best bet for investors.