Technical Corner: Why Free Cash Flow Is the Real Indicator of Value

When analysts talk about what really drives a company’s value, they often focus on one number: free cash flow (FCF). Although net income (also known as earnings) shows a company’s profitability, free cash flow reflects the firm’s ability to generate cash that can be used to pay debt, repurchase shares, or reinvest in growth. In other words, free cash flow drives shareholder returns.

Still, what is free cash flow? FCF is the amount of cash a company has left after accounting for spending on operations and capital assets. Free cash flow is typically calculated as:

FCF = Cash Flow from Operations – Capital Expenditures

Operating cash flow captures money earned from the business’s core operation. Notably, it adds back non-cash expenses (such as depreciation) to net income. Capital expenditures (CapEx) represent investments in long-term assets such as plant, property, and equipment (PP&E). In short, FCF is a way for investors to see what is left after maintaining and growing the business from CapEX.

Investors value FCF because the numbers are harder to manipulate. Through savvy accounting adjustments, such as strategic depreciation methods (straight-line vs. accelerated) and inventory accounting (LIFO vs. FIFO), companies can influence their earnings. However, generating consistent cash flow is proof of company strength. Free cash flow is also the foundation of discounted cash flow (DCF) models, where analysts project a company’s FCFs and discount them to the present to estimate intrinsic value. The higher and more stable a company’s free cash flow, the higher valuation it tends to receive.

While FCF offers a clear view of cash generation, it is important to acknowledge its limitations. FCF can be a misleading metric in the short term. For instance, when a company invests heavily in capital expenditures in a given year, its FCF will decline. Unlike accrual accounting, where CapEx is treated as a long-term asset and is gradually expensed through depreciation over several years, FCF reflects the entire cash outflow in the year the expenditure occurs. As a result, FCF can temporarily appear weaker during years of heavy investment.

Nonetheless, free cash flow is an important metric, and recognizing FCF is a crucial first step towards understanding company performance and how it creates value.