The Importance of the Free Cash Flow Factor

One of the most important factors to consider when analyzing a company from a fundamental perspective is that company’s ability to generate free cash flow. Cash flow represents the flow of cash earned and spent in a company. This pattern reveals how much money is available in a company at a given time. This is often a key measure of a company’s true health. If a company is paying out expenses faster than it is generating revenue, it can result in poor cash flow.

A company’s cash flow is calculated by subtracting the operating earnings figure from the capital expenditures figure. The reason why free cash flow is an important variable to look at is because if the company is experiencing negative flow, then they will have to look elsewhere for funds to even think about growing the business. If, on the other hand, there is an abundance of cash left over, it can then be allocated for growing and expanding the business. 

By virtue of having a healthy free cash flow situation management has a lot of flexibility in its decision making. They can internally finance new projects or add new product lines and penetrate new markets without the need to go to banks to borrow money or selling additional stock to raise capital. Many times companies borrow their way right into failure or sell so many shares that there is no way they can ever earn enough to justify a higher stock price.

The bottom line is that if a company cannot generate free cash flow and eventually become self-financing, it is only a matter of time before growth is stopped, funds cannot be borrowed and, of course, the stock is so low that no one wants to purchase another secondary offering. This is why the free cash flow statistic needs to be closely analyzed by a fundamental analyst.

In addition to do internal financing free cash flow allows a company to do other things as well. For instance, it provides companies the ability to pay and increases dividends, which is very important in the stock market now that dividends are only taxed at the 15 percent rate. Given this tax change many fundamental analysts look at a company’s ability to use free cash flow to pay and raise dividends as it is an extremely important factor in the stock market.

Another important point to consider is that companies can use their free cash flow to buy back stock, which is certainly beneficial to stockholders. Typically, when a company sees its own shares as an attractive investment this is very positive on a few fronts. First, the amount of shares becomes reduced but the earnings and other numbers remain the same. This means the price-to-earnings ratio, PE to growth rate, price to sales, and other key financial ratios will all become lower and attract additional investor interest. Second, stock buybacks are also a powerful psychological factor that demonstrates management’s confidence in its abilities and its future.

Just make sure to pay attention to free cash flow when selecting stocks from a fundamental perspective. Remember that companies with free cash flow can grow the business, build factories, open new stores and develop new products to fuel profits and reward shareholders with dividends, stock buybacks and higher stock prices.

Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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