Why is Free Cash Flow an Important Metric for Investors?

The Merchants Trust seeks to identify under-valued companies with strong fundamentals (which include factors such as a company’s profitability, revenue, liabilities, and growth potential), typically described as a value approach to investing. This often means going against the market consensus and finding opportunities others have missed. To find these diamonds in the rough, the managers of Merchants use a variety of analytical metrics, one of which is free cash flow. This is an important measure for income-seeking investors as it shows how much cash a business has available, after reinvesting in its own operations, to pay for acquisitions, to pay down debt or to distribute to shareholders through dividends or buybacks.

Free cash flow is an accounting term that indicates whether a business is making enough money to maintain itself while still making a profit. In other words, it’s the net cash made from operating activities minus capital expenditure (“CapEx”). CapEx reduces the cash available to shareholders and creditors, which is why it’s included in investment analysis. Positive free cash flow means the business has sufficient money to make acquisitions or distribute to shareholders through dividends or other means.

While it might sound like net income (defined as sales minus the cost of goods sold, expenses, taxes and interest), free cash flow is different. Whereas net income represents profit, free cash flow indicates whether a company’s net cash reserves have increased or decreased. It is possible for free cash flow to be higher (or lower) than net income – for example, a start-up may be generating sales which bring in cash – but as the business is still at an early stage of growth, it isn’t yet making a net profit. Earnings before interest, taxes, depreciation and amortisation (EBITDA) also has a lot in common with free cash flow, but does not include the cost of sustaining the business. Therefore analysts generally believe free cash flow gives a truer picture of a company’s profitability.

As mentioned previously, Merchants invests in underpriced quality businesses, traditionally known as a ‘value’ approach to investing. Value investors move away from the broad market consensus to look for opportunities that others miss, where businesses with attractive fundamentals diverge from their share prices. In other words, fundamentals look solid, but the share price seems relatively low. These companies are considered to be trading below their intrinsic value.

Merchants’ portfolio managers, Simon Gergel, Richard Knight and Andrew Koch, use multiple investment metrics to analyse potential value opportunities, including a strong emphasis on free cash flow, typically one of the truest measures of corporate performance. They also look at asset value and other valuations, but, says Simon, “cash is one of the purest measures, and tends to be the one we focus on most.” Simon explains that once a business has spent all the money it needs to on sustaining operations and organic growth, , whatever cash is left over can either be used for further growth through acquisitions, paying down debt or returned to shareholders in dividends or buybacks.

So, the managers ask: if a business is sustaining and growing after all those deductions, how much cash is left over? The Merchants managers need to understand what companies are doing with their cash and whether it will, ultimately, be used to improve shareholder returns. To achieve this, Merchants take the ratio of that cash to the market value to calculate the free cash flow yield. Simon explains, “If a company generates £10 million of free cash and the value of that business is £100 million, the free cash flow yield is 10%.” This free cash flow calculation is an important consideration in the analysis of a company’s long-term investment potential, for growth in income as well as capital.