The term “free cash flow” has a rather curious history, with a variety of shifting meanings over the last thirty-odd years. It has always carried the meaning of cash flow in excess of that required for operations, but the nuances, implications, and use of the term have undergone quite a transformation. I’m going to outline three ways to think about and calculate free cash flow, and argue in favor of the last and most recent.
The term originated with Joel M. Stern in 1972 as an alternative to earnings. Stern initially calculated it as “net operating profits after taxes minus the amount of new capital investment required in order to generate future profits.” It was Stern who suggested subtracting capital expenditures from cash flow when doing discounted cash flow analysis. This is a rough equivalent to Warren Buffett’s “owner earnings,” as spelled out in the appendix to his 1986 shareholder’s letter.
Also in 1986, coincidentally, Michael C. Jensen, published an article called "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers." After defining free cash flow as “cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital” (following Stern’s lead), Jensen wrote, “Such free cash flow must be paid out to shareholders if the firm is to be efficient and to maximize value for shareholders.” Jensen saw free cash flow as a problem rather than a good thing:
Conflicts of interest between shareholders and management over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than invest it below the cost of capital or waste it through organizational inefficiencies.
For Jensen, free cash flow couldn’t finance growth, since by definition it was excess to the cash flow needed for growth--it was an inefficiency. Jensen’s theory was widely discussed by scholars and for more than two decades free cash flow remained an inefficiency, a source of “agency costs.” Basically, free cash flow provided managers opportunities to waste money on unprofitable investments. Many papers were written supporting this theory. For the purposes of these papers, free cash flow was generally defined as undistributed cash flow in excess of that needed for positive net present value projects and was calculated as operating income before depreciation minus taxes, interest expense, and total dividends; often capital expenditures were deducted as well. Over the years, though, a revised calculation came into general use: cash flow from operations minus capital expenditures minus dividends paid.
Unlike scholars, investors continued to follow Stern’s idea of using free cash flow as an alternative to earnings in order to evaluate a company’s quality and value. Seth A. Klarman’s brilliant preface to the sixth edition of Graham and Dodd’s Security Analysis, written in 2009, includes the following passage:
While Graham looked at corporate earnings and dividend payments as barometers of a company’s health, most value investors today analyze free cash flow. This is the cash generated annually from the operations of a business after all capital expenditures are made and changes in working capital are considered. Investors have increasingly turned to this metric because reported earnings can be an accounting fiction, masking the cash generated by a business or implying positive cash generation when there is none. Today’s investors have rightly concluded that following the cash--as the manager of a business must do--is the most reliable and revealing means of assessing a company.
In 1988, the Security and Exchange Commission required that companies provide not only a balance sheet and an income statement in their reports but a cash flow statement as well, and the numbers in the three reports had to be reconciled. At some point, this forced investors to start looking at the other items in the investing section of the cash flow statement besides capital expenditures. Doing so led Stephen Penman, for example, to use cash flow from investments rather than capital expenditures to calculate free cash flow in his now standard textbook, Financial Statement Analysis and Security Valuation. Penman is hardly alone in this practice.
The term free cash flow, then, has come to be thought of in three different ways.
- Stern’s original concept, seconded by Buffett and Klarman: free cash flow as an alternative to earnings per share and the basis for discounted cash flow analysis. These days one usually calculates it by taking cash flow from operations and subtracting capital expenditure--often subtracting only those capital expenditures necessary for maintaining operations. If one is then using this for discounted cash flow analysis, comparing it with the company’s enterprise value, one must add back after-tax interest expense to get unlevered free cash flow.
- Free cash flow as an inefficiency, as in Jensen’s 1986 article. Here one starts with the above definition and then subtracts dividends paid.
- The sum total of all cash flows from operations and investments (in the cash flow statement, cash flows from investments are the negative of Penman’s term cash investments). In essence this means subtracting not only capital expenses but also acquisitions, and adding back divestitures and various other investment-related income.
When I’m not doing discounted cash flow analysis--when I’m looking at free cash flow growth, free cash flow margin, free cash flow to assets, or free cash flow to price--I prefer definition #3, which puts me in the minority of value investors. Basically this definition makes no distinction between capital expenses and acquisitions. There's a strong case to be made, especially when it comes to tech and pharmaceutical companies, that this distinction no longer applies. And if we treat acquisitions as capital expenditures, why should divestitures not diminish capital expenditures?
It has been argued that acquisitions are usually one-time expenditures, but I've found that not to be the case. If you screen on Portfolio123 for companies that reported acquisitions over the last year, well over half (as high as 80%, depending on what universe you look at) also reported acquisitions either the year before or the year before that.
What about cash from other investing activities? Let’s take Bloomin’ Brands (BLMN), for example. In 2016, the company reported over $530 million in cash proceeds from sale-leaseback transactions--basically, they sold 153 restaurants at fair market value. Now when all those restaurants had been originally bought or built, the cost had been accounted as capital expenditures, and was deducted from free cash flow. So when they were sold, why shouldn’t that be added to the company’s free cash flow?
On a more basic level, if we’re using free cash flow as Seth Klarman suggests we do--as a way to “follow the cash”--does it make sense to ignore acquisitions, divestitures, and other investment activity? How exactly does one justify deducting the purchase of a building from free cash flow but not the purchase of a subsidiary? Especially if the subsidiary will contribute more immediately to operating income than the building?
Interestingly, Stephen Penman’s problem with discounted cash flow analysis is that, as he writes, “GE (GE) earned one of the highest stock returns of all U.S. companies from 1993–2004, yet its free cash flows are negative for all years except 2003. . . . During the years 1996–2000, [Starbucks’ (SBUX)] stock price more than doubled. Yet the free cash flows are consistently negative.” I can provide plenty of more up-to-date examples of companies whose annual free cash flows have been negative for five years running while their price has doubled: Netflix (NFLX), Baidu (BIDU), Cheniere Energy (LNG), Diamondback Energy (FANG), Cimarex Energy (XEC), Alnylam (ALNY), Exelixis (EXEL), Seattle Genetics (SGEN), SMI (SMI), Amerco (UHAL), and so on. These companies are consistently spending more on investments than they’re getting from operations.
But what else do these companies have in common? They usually either have terrible earnings or terrible total-debt-to-EBITDA ratios. In fact, if you take the fifty largest companies (excluding those in the financial, real estate, and utilities sector) with negative free cash flows over each of the last five years but whose price has doubled nonetheless, an astonishing forty of them (80%) reported either a negative EBITDA or a debt-to-EBITDA ratio greater than 4.0 in their most recent annual report. If you look at the S&P 500 as a whole, only 16% of companies outside those three sectors reported negative EBITDAs or debt-to-EBITDA ratios greater than 4.0. In other words, the negative free-cash-flow companies really need to generate some positive free cash flow in order to increase their earnings and/or pay down their debts. I'm not saying that companies can't succeed with consistently negative free cash flows--clearly Netflix (NFLX), Baidu (BIDU), SMI (SMI), Amerco (UHAL), and InterXion (INXN), all of which have decent debt-to-EBITDA ratios, have. But it's much harder to do so.
I recently created a simple ranking system based on a company’s recent free cash flow. Every company is ranked equally on five factors: the ratio of its trailing twelve-month free cash flow to its total assets, its total sales, and its fully diluted market cap; its year-to-year free cash flow growth; and the ratio of its unlevered free cash flow to its enterprise value. For all of these I used the contemporary definition of free cash flow as cash flow from operations plus cash flow from investments, with the exception of the last, for which I used the more conventional definition of unlevered free cash flow as cash flow from operations minus capital expenditures plus after-tax interest expense. Using Portfolio123, I then looked at the performance of this ranking system on stocks in the S&P 1500 (excluding utilities, REITs, and MLPs) with a one-month rebalance since January 1999. The result (including dividends) is below. As you can see, it's definitely worthwhile taking free cash flow into account when investing.
Lastly, I’d like to recommend five undervalued companies with good, healthy cash flows that I think are worth investing in: Forward Pharma (FWP), Points International (PCOM), Cambium Learning Group (ABCD), Triple-S Management (GTS), and Bayer (OTCPK:BAYRY).
Disclosure: I am/we are long FWP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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