A sometime series: Valuing securities (this time by using free cash flow)

Fundamentally, buying stock in a company like Procter & Gamble (PG) is like trying to determine how much money to lay out today for shares of PG in light of the perceived potential for a stream of cash that could flow your way as a shareholder.

Operationalizing this method requires an estimate of future cash flows coming to you from the corporation. Dividend payouts represent a concrete expression of cash flowing to shareholders on a routine basis. However, many companies, even established ones like Berkshire Hathaway (BRK.A) and Cisco Systems (CSCO), don’t pay dividends. Moreover, there has been a secular corporate trend towards reducing dividend payouts in favor of retaining earnings for internal projects.

As such, I like to value securities using measures of free cash flow. Free cash flow (FCF) is 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 (Jensen, 1986: 323). Stated another way, it's the cash that is 'free' for distribution to shareholders after all investments have been financed (Stewart, 1991: xvii).

The most common expression of FCF is as follows:

free cash flow (FCF) = cash flow from operations - capital expenditures

I prefer FCF for a number of reasons. Fundamentally, it helps answer an essential question that should be on investors’ minds: "Based on the capital that goes into an enterprise, how much can I get out?" Moreover, measures of FCF are less influenced by accounting tricks that often distort earnings numbers on income statements. Free cash flow tends to a reasonable gauge of the true value creating power of an enterprise.

FCF approaches using the equation above are less effective when operating cash flows or capital expenditures do not accurately reflect inflows and outflows central to the ongoing enterprise. Financial firms, for instance, commonly employ sources of capital that are not considered capital expenditures by accounting standards. Adjustments must be made to render FCF meaningful in such situations.

It should be also noted that negative FCF might not be a bad thing. For example, young enterprises such as SunPower Corporation (SPWR) often invest heavily in the present with an eye towards creating value in the future. From a discounted cash flow perspective, the challenge becomes forecasting the size and timing of future FCF values.