Free Cash Flow
Free Cash Flow (FCF) represents the cash a company generates from its operations after accounting for capital expenditures (CAPEX). Also referred to as "owner earnings", this cash can be used for reinvestment, debt repayment, dividends, or share buybacks. FCF is preferred by many investors (over net income) because it provides a clearer picture of cash availability and operational health.
General Formula:
FCF = Operating Cash Flow (OCF) − Capital Expenditures (CAPEX)
A few variations to this formula exist. The one we prefer also subtracts stock-based compensation (SBC). SBC represents a real economic cost to shareholders through share dilution, even if it's not a cash expense. For EMCLOUD companies collectively, SBC represents over 18% of revenues. Which is quite high but typical for young, growing companies.
FCF Per Share
Calculating FCF on a per share basis is important due to the reasons just mentioned. If a company is paying too much in SBC and using other means of equity financing, FCF could be rising faster in actual dollars but not keeping pace on a FCF per share basis. This is critical when it comes to compound annual growth, which is why we've created a page solely for compound annual growth rates (CAGR).
On this page, you'll notice that FCF on a per share basis tends to lag behind actual FCF. For some companies, this can be a huge difference. This difference can become even more massive after the effects of compounding over time are taken into account. The table below shows the 10-year CAGR for both FCF and FCF per share. Notice how the rates can vary from a fraction of a percent to amounts that are much higher.
FCF vs Net Income
Net income depends heavily on the company's application of accounting standards (GAAP or IFRS). Cash flow, on the other hand, is much harder to manipulate.
Key Differences
| Aspect | Free Cash Flow | Net Income |
|---|---|---|
| Basis | Cash-based | Accrual-based |
| Includes | Adjustments for non-cash items and CAPEX | All revenues and expenses, including non-cash (i.e. depreciation) |
| Purpose | Measures liquidity and financial flexibility | Measures profitability |
| Statement | Derived from the cash flow statement | Found on the income statement |
| Volatility | Can vary with investment levels (i.e. CAPEX) | Generally smoother over time |
Notice the bottom aspect, volatility, from above. There are a few key reasons for net income to appear smoother and more consistent. A large capital expense could have a big, direct impact on cash flow within a single year. This large expense will then be capitalized (including an asset being added to the balance sheet) in which depreciation will be split and expensed over a defined number of years that's much smaller than the total CAPEX amount.
Since companies are aware that Wall Street prefers the smoother net income amounts (consisting of steady year-to-year growth), they are incentivized to apply accounting standards that produce such a result. In reality, real economic profits and cash flows are more volatile, which is why it's important to pay attention to the relationship between net income and cash flows.
Valuation
Both FCF and net income are commonly used to value companies. Price-earnings (P/E) ratios are the most popular income-related valuation metric while Enterprise Value to FCF (EV/FCF) is a very popular cash flow metric.
P/E ratios are calculated on a per share basis using the following formula:
P/E = Share Price / Earnings Per Share (EPS)
EV/FCF is calculated by using total dollar (currency) amounts. The approach is from the perspective of buying the entire company. Enterprise Value is preferred because it takes debts and cash balances into account. An in-depth comparison can be found here: Enterprise Value vs. Market Capitalization: What's the Difference?.
One more important thing to note here is that most future estimates are based on revenues and earnings, not cash flows. On a forward basis, a P/E could be calculated on the upcoming year's earnings projections, whereas the FCF-based valuation is based on what happened in the past (i.e. trailing 12 months (TTM)). Even though future projections have flaws (too optimistic more often than not), it's still important to examine multiple valuation metrics.