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Calculating Real Free Cash Flows

The present value of Free Cash Flows is perhaps the most commonly used method of valuation for any project. However, when used in stock market analysis the Free Cash Flow calculation can be very misleading.

There are several definitions of Free Cash Flow, but this is the one I will be using: Free Cash Flow is the amount of the cash a company has left over from its operations after paying all of its expenses for maintenance. This cash can then be reinvested in the business or paid out to shareholders. As investors such as Warren Buffett argue, stock-holders are the owners of the business anyway, and therefore the Free Cash Flow generated should be treated in the same way whether it is paid out or reinvested.

Unfortunately, this concept of Free Cash Flow poses several practical problems for calculations. Firstly, it differs from the academic definition of Free Cash Flow, which states that:

Free Cash Flow = EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

The problem arises from the item ‘capital expenditure’. Whilst this term is often used by academics and CEOs alike, there are in fact too types of capital expenditure – Maintenance Capex and Growth Capex. When calculating Free Cash Flows, it is the Maintenance Capex figure that is important. Investors that simply use the Capex figure provided by a company’s Cash Flow Statement are therefore miscalculating Free Cash Flow.

Nevertheless, the usage of Maintenance Capex also provides problems, as companies are not required under accounting laws to separate maintenance and growth expenditures. This means that investors are often left to estimate these figures. Whilst there are several methods of doing this, the necessity of estimation highlights the important of what Warren Buffett calls the ‘Circle of Competence’. Without a clear understanding of the business, it becomes practically impossible for an investor to determine the appropriate maintenance figure, thus rendering their Free Cash Flow calculations meaningless. This is why Buffett himself prefers simple and stable businesses such as Burlington Northern Santa Fe, where maintenance costs can be clearly identified over a significant period of time.

Finally, investors should be aware that the Growth Capex figure can be negative. Theoretically, there is a sum of money that is necessary to maintain a business’s market position. If the total Captial Expenditure figure is below this, the business is effectively disinvesting. This is one of the most common tricks of management - to reduce Growth Capex in bad years, thus lowering the total Capital Expenditure figure and thus seemingly increasing Free Cash Flow. Alert investors should not be mislead.