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Free Cash Flow – A Valuable Tool

 

Free Cash Flow is one of the most instructive financial metrics used to determine the financial health of a company. It is financial jargon for what is left over when one subtracts the amount of cash needed to run a business (called Capital Expenditures) from the amount of cash it generates (called Cash Flow From Operations).

Companies that generate higher Free Cash Flow tend to be safer investments than those that generate lower Free Cash Flow.   Companies can use their excess cash to pay dividends to investors and buy back their own stock, both of which are very beneficial to shareholders. However, younger, fast growing companies tend to generate less free cash flow than their mature slower growing competitors because they use the cash in order to fund their growth.  Over time, small, lower free cash flow generating companies can appreciate substantially, but on the downside they can also drop substantially in price if their growth plans do not materialize.

Another metric that goes hand in hand with Free Cash Flow is Free Cash Flow Yield. It is calculated by dividing the Free Cash Flow of a company by the market value of the company; the resulting number is expressed as a percent, which makes it easy to compare companies of different market values.

Whenever choosing investments one should always be aware of the Free Cash Flow and Free Cash Flow Yield.  Earnings are important also, but they can be manipulated through the use of non-cash items, which can affect the earnings number substantially.  Cash, on the other hand, is much harder to manipulate making it an essential metric to use.

Take a look at two companies, UPS and Fedex, and compare their Free Cash Flows.

(in thousands)

UPS Fedex
Cash Flow from Operations 7,216,000 4,688,000
Capital Expenditures 2,153,000 3,375,000
Free Cash Flow 5,063,000 1,313,000

 

As shown in the table above, UPS generates significantly more free cash flow than Fedex.   Interestingly, not only does UPS have higher Cash Flow from Operations than Fedex ( 7,216,000 vs 4,688,000), but also it has lower Capital Expenditures (2,153,000 vs 3,375,000).

To compare the two companies’e Free Cash Flow factoring in their different market values, divide the Free Cash Flows by the market value of each company. The results are as follows:

(in thousands)

UPS Fedex
Free Cash Flow 5,063,000 1,313,000
Market Value 85,870,000 36,710,000
Free Cash Flow Yield 5.89% 3.58%

 

As you can see above, the Free Cash Flow Yield for both companies is calculated by dividing the Free Cash Flows by the Market Values and multiplying the result by 100. UPS has a Free Cash Flow Yield which is significantly higher than that of Fedex.

This is great example of how two companies in the same industry can have widely different free cash flow yields. In our opinion, UPS is a more compelling investment since it has a significantly higher Free Cash Flow Yield.

 

 

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