In the financial world, free cash flow (FCF) represents that amount of capital of a company that they can distribute among the security holders – for example, equity holders, debt holders, preferred stock holders, convertible security holders, etc. According to some investors, though the main focus for all is on the earnings of the company, it can be faked hiding the "real" profit the company makes. However, it is very difficult to hide FCF and it provides a better view of the company's earnings.
Therefore, FCF = net income + depreciation – changes in working capital – capital expenditure (capex)
While, net income and depreciation of a company can be obtained form the income statement of the company, working capital details and capex is obtained form the prior and current balance sheets of the company. FCF can also be calculated subtracting capex from operating cash flow. FCF represents the money a company is left with after laying out money to increase its asset base.
FCF also allows a company to introduce new products in the market, acquire other companies, pay dividends to its shareholders, repay its debts – all these increase the value of its shares. Even negative FCF can indicate that a company is making large investments, which can have potential for high returns in the long term.
FCF is however different from net income of a company. FCF uses the net investment spending made by the company in the prior periods, while net income uses the depreciation value. Also, in FCF calculation we deduct the increases in net working capital, while we do not deduct this in the calculation of net income.
FCF is a good measure of a growing business that can pay out high dividends to its shareholders. According to discounted cash flow (DCF) valuation, the intrinsic value of a company "equals to the present value of all future free cash flows and the cash proceeds from its future sale." Thus, cash flows are used to pay out dividends to shareholders of the company.
Free cash flow for the firm (FCFF) is a measure of a company's profits after it has laid out money for all expenses and reinvestments. It is one of the most important criteria to check the financial condition of a company. A positive FCFF shows that a company is able to save money even after all expenses, while this is negative indicative bad financial heath of the company. It is calculated as
FCFF = Operating cash flow – expenses – taxes – changes in net working capital – changes in investment
Free cash flow to equity (FCFE) measures that amount that can be paid to equity shareholders of the company after laying out money for all expenses, reinvestment, and debt repayment. FCFE helps to determine the value of a company. Also, free cash flow yield is a measure of the overall return ratio of a stock. This is calculated by taking the free cash flow per share divided by the share price. A low ratio makes a stock less attractive to investors and vice versa.
However, one downside of using FCF-based valuations is that it undervalues companies that have potential to earn more through large investment. In that case, the FCF turns negative. It also overvalues companies that are badly run to make investments to destroy shareholder value.