Free cash flow: the number that can't lie as easily

I have invested publicly on eToro since August 2020, and one number appears in my notes more than any other: free cash flow. Every position in the portfolio you can see today passed this filter before I bought it. This article explains why. It is not a sophisticated preference. It is a defensive one.

Earnings are an opinion

Net income is the output of a long chain of judgment calls. Management chooses depreciation schedules, decides when revenue counts as earned, estimates how many customers will actually pay, and labels inconvenient costs as one-off. Each choice can be defensible in isolation. Stacked together, they give the same underlying business a reported-earnings range of easily plus or minus 30 percent.

Cash is different. Money either arrived in the bank account or it did not. Accountants can shift when a profit is recognized; they cannot shift when cash moves, only where in the statement it appears. That asymmetry is the entire argument.

What free cash flow actually is

Free cash flow is cash from operations minus capital expenditure. In words: the cash the business generates for its owners after paying to keep itself running. Both inputs sit on the cash flow statement, which makes this a two-line calculation anyone can do.

The word "free" is doing the work. Cash from operations alone flatters companies that must constantly reinvest just to stand still. Subtracting capex asks the harder question: after the machines are replaced and the stores refitted, what is actually left over?

A tale of two companies

Consider two companies reporting under identical accounting standards. Company A reports $100M of net income but only $20M of free cash flow: it spends heavily on capex, and growing receivables and inventory absorb cash every year. The profit exists on paper while the bank account barely moves.

Company B reports $50M of net income and $80M of free cash flow. Heavy depreciation from past investment suppresses its reported earnings, but the business is now capital-light and the cash arrives. On a price-to-earnings screen, A looks twice as profitable as B. On a cash basis, B generates four times as much for its owners.

At the same price, I know which one I would rather own. The income statement gave the wrong answer; the cash flow statement gave the right one.

FCF yield: a bond coupon that can grow

My main valuation tool follows directly: free cash flow divided by enterprise value. Enterprise value rather than market capitalization, because debt holds a claim on that cash before I see any of it.

A company producing $80M of free cash flow on a $1,000M enterprise value yields 8 percent. I read that like a bond coupon, with one difference that matters: a coupon is fixed, while a business's cash flow can grow — or shrink. An 8 percent yield growing 5 percent a year is a very different asset from an 8 percent yield in slow decline, which is why the yield is where my analysis starts, never where it ends.

Where free cash flow misleads

Harder to manipulate than earnings does not mean impossible. Four caveats I apply to every calculation.

First, capex conflates growth and maintenance. A company building new capacity looks temporarily worse than one coasting on aging assets, so I estimate maintenance capex separately, even roughly. Second, stock-based compensation: the cash flow statement adds it back as a non-cash expense, but shares issued to employees dilute my ownership as surely as cash paid out. I subtract it — a haircut that routinely cuts the reported free cash flow of software companies by 20 to 40 percent.

Third, working capital swings distort single years. A company that stretches its payables or drains inventory can post one flattering year that quietly reverses the next, which is one reason I never rely on a single year. Fourth, capitalized software development moves what is economically an operating cost into capex — or into "investing" lines that some published FCF definitions conveniently ignore. The footnotes settle it.

One number, held loosely

A business is not a formula, and I have never bought anything on FCF yield alone. Competitive position, management, the balance sheet, and the durability of the cash flows all matter, and none of them compress into a single figure.

But if I were allowed exactly one number before forming a first opinion of a company, this is the one I would ask for. Earnings tell me what management would like me to believe. Free cash flow tells me what happened.