Free Cash Flow
GeneralFree Cash Flow (FCF)
The cash a business generates from operations after deducting capital expenditure. FCF represents the actual money available to pay dividends, reduce debt, buy back shares, or make acquisitions โ the truest measure of financial health.
Definition
Free Cash Flow (FCF) is the cash a business generates from operations after deducting capital expenditure (capex) required to maintain and grow the asset base. It represents the cash available to the company after funding its operating requirements and ongoing investment needs โ cash that can be used for debt repayment, dividends, share buybacks, acquisitions, or building reserves.
FCF is widely considered the most honest measure of a company's financial performance and the foundation of intrinsic value in discounted cash flow (DCF) analysis. Unlike net profit (which includes non-cash items and can be influenced by accounting choices), FCF reflects actual cash generation.
FCF = Operating Cash Flow โ Capital Expenditure
Or alternatively:
FCF = EBITDA โ Taxes โ Change in Working Capital โ Capex
Formula
Free Cash Flow = Operating Cash Flow โ Capital Expenditure (Capex)
Where:
- Operating Cash Flow = Net Profit + Depreciation โ Change in Working Capital โ Taxes
- Capex = Net investment in property, plant, equipment, and intangibles
FCF per Share = Free Cash Flow / Shares Outstanding
FCF Yield = (FCF / Market Cap) ร 100%
Price/FCF = Market Cap / Free Cash Flow
Worked Example
Tata Consultancy Services (TCS) โ illustrative numbers:
| Item | FY 2025 (โน crore) |
|---|---|
| Revenue | 2,40,000 |
| EBITDA | 62,400 (26% margin) |
| Tax | 14,000 |
| Change in Working Capital | โ3,000 (WC increased) |
| Capex | 4,200 |
| Free Cash Flow | โน41,200 crore |
FCF Margin = โน41,200 / โน2,40,000 = 17.2% โ excellent for a technology services company.
If market cap is โน14,00,000 crore: FCF Yield = โน41,200 / โน14,00,000 = 2.94%
Compare to 10-year G-sec yield of 7% โ TCS's FCF yield is lower, reflecting the premium paid for its quality and growth.
Key Things to Know
- Depreciation and FCF: Depreciation is added back in operating cash flow (it's a non-cash expense). However, capex (which maintains and replaces depreciating assets) is subtracted. A company where capex consistently exceeds depreciation is spending more to grow/maintain assets than the accounting charge suggests โ important for asset-heavy businesses.
- Maintenance vs growth capex: Sophisticated analysts separate capex into maintenance capex (required to maintain current operations) and growth capex (investment in new capacity). Maintenance capex determines "owner earnings" (Warren Buffett's preferred FCF measure). Growth capex is discretionary and signals management's confidence in future returns.
- FCF in DCF valuation: The intrinsic value of a business in a DCF model = ฮฃ[FCF_t / (1 + WACC)^t] + Terminal Value. The accuracy of the FCF forecast (especially the growth rate used for terminal value) dominates the valuation. A 1% change in long-term growth rate assumption can change DCF value by 20โ30%.
- Working capital impact: Changes in working capital affect FCF directly โ an increase in working capital (more inventory, more receivables) reduces FCF even if profit is unchanged. Fast-growing businesses often have FCF significantly below net profit because growing revenue requires more working capital.
- FCF vs EBITDA: EBITDA is operating profit before interest, tax, depreciation, and amortisation โ a proxy for operating cash generation. FCF is more complete: it accounts for actual taxes paid, working capital changes, and capex. A company trading at low Price/EBITDA but high Price/FCF may be investing heavily in growth (acceptable) or consuming cash inefficiently (a red flag).