ANZ Finance blog | Free Cash Flow | McGraw Hill Australia New Zealand

Free Cash Flow: The Driver of Shareholder Value

Published 16 July 2020

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

Free Cash Flow -- McGraw Hill ANZ Finance Blog -- Australia and New Zealand

When I first became interested in investing, I read a lot of ‘how to invest’ books and there’s a lot of very good ones. One of the best is Peter Lynch’s One Up on Wall Street, in which he explains how ordinary investors can get the edge on the professional fund managers by keeping an eye out for great companies and great products and, if you spot one, following up to see if it’s possible to buy the company’s shares on the stock exchange. He bought shares in Dunkin’ Donuts because he loved the coffee and could see that all the other customers did too.

Sometimes, though, these types of books branch and splinter in so many different directions that the budding investor would quickly fill a page with notes of important things to look for in investment prospects. One thing that is rarely mentioned, possibly because the authors think that it’s a little bit too complicated for ordinary investors to understand, is actually the true driver of shareholder value. This is something called free cash flow (FCF).

‘Free’ cash flow is cash that is ‘free’ to be distributed to the shareholders. It’s what’s left over from the operating cash flow (OCF) after additions to plant & equipment and working capital. It’s what makes it to the investor’s pocket.

If you own a corner store, running the store gives you some operating cash flow. You buy wholesale and sell retail and you generate OCF. This is not the amount that ends up in your pocket. You might have invested in a new refrigerator (plant & equipment) or you might have invested in a little more inventory (working capital). It’s only after these things have been subtracted that you are left with cash in your pocket. Isn’t it logical to say that the amount of cash that makes it to your pocket, your FCF, is what makes your corner store valuable to you? The more FCF, the more valuable your store!

It doesn’t matter if it’s a corner store that you own and operate or if it’s a corporation in which you have a share, the value of your investment depends on how much money is leftover from doing whatever it is that the company does after subtracting investments in plant, equipment and working capital. It is to ‘free cash flow’ (sometimes called ‘cash flow to investors’) that we should turn to in the company’s annual report. This will allow us to see how much cash will make its way to your pocket if you invest in the company’s shares. It’s the most important determinant of value. If no cash ever made it to the corner store owner’s pocket, there would be no point in running the store. If no cash was left over for the investor in a large corporation, there would be no point owning the shares.

Great managers will be growing free cash flow over time by coming up with great ideas, new markets, new products, that return more than what they cost (formally, ideas that have positive net present values). If the investor goes to the company’s annual report and sees low or declining free cash flow, it might be best to move on and look for another investment prospect. All of the things that are covered in investment books are useful and interesting but it’s how much cash that ends up in the investor’s pocket that matters the most.

Discussion Question

Go to a company’s annual report (more than one if you can) and find the free cash flow. Is it going up or down? Is the company’s market value going up or down?

Further Reading

Part two of Financial Institutions, Instruments and Markets 9e covers the equity markets. If you are studying corporate finance, you will find free cash flows (or cash flow to investors) treated prominently. The free cash flow concept connects the company’s decision-making, its choices of ideas to pursue, with the market value of the firm.