Seasoned investors should be familiar with Alfred Rappaport’s view that ‘profits are an opinion, cash is fact’, yet a great deal of company analysis still relies on traditional measures of profits such as EBITDA (earnings before interest, tax, depreciation and amortisation) and EPS (earnings per share).

Rappaport argued that since bond holders valued their investments by discounting back future cash flows, equity investors should do the same with their investments.

Ultimately, profits are just an accounting principle whereas actual cash in the company’s accounts determines how much it can invest to grow the business and how much it can return to shareholders.

WHY CASH MATTERS

While profits are a summary of a company’s earnings on account after expenses, free cash flow comes from operating cash flow received and paid into the company’s bank account.

The more cash a company has, the better its ability to invest in growth opportunities or to meet any unexpected claims or other liabilities.

In the same way we calculate a company’s dividend yield by dividing the payout by the share price, expressed as a percentage, dividing the free cash flow per share by the share price gives us the free cash flow yield.

The higher the free cash flow yield the more solvent and therefore the more attractive the company is as an investment and vice versa.

Companies which generate lots of free cash flow don’t need to go to their banks or their shareholders for money when they want to make an investment, whether they need new equipment or new premises or want to expand by buying another company.

In contrast, companies which need to borrow to grow their business run the risk that they amass too much debt and can’t pay their interest costs on top of all their other expenses, sending them into bankruptcy.

DEFINING FREE CASH FLOW

Because not all companies operate in the same way, there are a couple of approaches to defining free cash flow.

The first, and simplest, is to go to the cash flow statement and pick out ‘operating cash’ (also referred to sometimes as ‘net cash from operating activities’) and ‘capital expenditure’.

By subtracting capital expenditure – which covers any spending the company requires to maintain its business at the current level – from operating cash we get free cash flow.

The second method of calculating free cash flow is to take revenues and then subtract all the costs associated with generating those revenues, from cost of goods sold to operating costs, interest costs and the net investment in operating capital.

Where the calculations can get tricky is in defining the real level of investment needed to keep the company ticking over, namely before any growth investments.

Companies which own lots of fixed assets which they must maintain or replace face a constant drag on their cash flows, whereas companies which are ‘asset-light’ and mainly provide software or services need to invest much less in maintenance.

However, this has become a hot topic among investors in software stocks as it could be argued they need to invest constantly in their products simply to keep them up to date, so the issue isn’t completely clear-cut.

STAKING A CLAIM

Terry Smith, who runs Fundsmith Equity Fund (B41YBW7), is a long-standing advocate of free cash flow as a guide to investing.

‘We take the view we own those cash flows,’ says Smith. ‘Free cash flow, whether it’s used to acquire things, to invest further in the company or we receive it in dividends, that’s what we own.’

The Fundsmith boss says the fund’s aim is to invest only when free cash flow per share as a percentage of a company’s share price – i.e. the free cash flow yield – is high relative to long-term interest rates and when compared with the free cash flow yields of other investment candidates both within and outside of its portfolio.

‘Our goal is to buy securities that we believe will grow and compound in value, which bonds cannot, at yields that are similar to or better than what we would pay for a bond.’

Unsurprisingly, legendary value investor Warren Buffett is also a keen watcher of free cash flow yields and typically likes to buy stocks with yields approaching double digits.

Chevron (CVX:NYSE), which Buffett started buying in late 2020 and now one of his top five public holdings, yields around 12% on a free cash flow basis even after a 35% rally this year thanks to the spike in energy prices.

FTSE 100 FREE CASH FLOW YIELDS

In the UK, oil giants BP (BP.) and Shell (SHEL) currently trade on 12 month-trailing free cash flow yields of 18.3% and 16.8% respectively, according to figures from SharePad.

This makes sense as the energy companies have stopped spending on developing new fields, under pressure from the environmental lobby, and are spending a minimal amount on maintenance while reaping the benefit of soaring demand and record prices, particularly for natural gas.

Imperial Brands (IMB) also scores highly on free cash flow yield as its products are bought in high volumes on a regular basis by millions of people worldwide, creating steady cash flows, while its maintenance spending is low, allowing it to invest in new generation products.

At the other end of the spectrum, with free cash flow yields of just 0.6% and 0.9%, are utility companies Severn Trent (SVT) and SSE (SSE) which use almost all their operating cash flow on capital spending and interest payments.

Disclaimer: The author (Ian Conway) and editor (Daniel Coatsworth) owns units in Fundsmith Equity Fund.

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