The showdown of Cash vs. Accounting magic

Most media, analysts and investors tend to overly focus on revenue growth and associated net profits. By following their reports and responses to the publication of quarterly results it always comes down to if earnings per share (EPS) beat consensus expectations and by how many cents. Moreover, companies also need to upgrade their next quarter’s EPS guidance by a healthy margin, otherwise the shares could retreat if this EPS upgrade remains absent or is deemed too little, too late.

Whilst recognizing the importance of solid and predictable future revenue growth and EPS growth, it is even more important to assess the trend in free cash flow (FCF) generation. Whilst the calculation of EPS leaves room for flexible accounting, the change in hard cash in a year is much harder to manipulate, hence presents a more trustworthy picture. FCF and Net Profit, while related, are distinct financial metrics that serve different purposes. FCF is a key financial metric that helps assess the financial health and performance of a company. It represents the cash a company generates from its operations after accounting for capital expenditures necessary to maintain and expand its asset base.

 

Here are the main features and key aspects to consider when looking at FCF:

FCF is calculated by subtracting capital expenditures from a company's operating cash flow (OCF). The formula is:

FCF = OCF minus Capital Expenditures

OCF: The cash generated or used by a company's core operating activities, including revenue, expenses and changes in working capital.

Capital Expenditures: The funds spent on acquiring, upgrading, or maintaining assets like property, plant, and equipment.

Positive FCF indicates that a company is generating more cash from its operations than it is spending on investments, which is a healthy sign. Negative FCF suggests that a company may be spending more on investments and growth than it is generating from its operations, which can be a cause for concern.

FCF offers several advantages over Net Profit when it comes to assessing a company's financial health and performance. FCF is a cash-based metric, whereas Net Profit is an accounting-based metric. FCF reflects the actual cash generated or used by a company's operations, providing a more direct measure of a company's ability to generate and manage cash. Net Profit can be influenced by non-cash items like depreciation and amortization, which are non-cash items and as such don't affect cash flow. Net Profit is also subject to accounting rules and accruals, which can sometimes distort a company's performance. FCF is less susceptible to these accounting manipulations, providing a clearer picture of a company's financial health. Hence, FCF provides a more realistic evaluation of a company's ability to meet its financial obligations, such as debt service and dividends.

Net Profit does not necessarily reflect a company's liquidity or its ability to meet short-term cash needs. FCF accounts for capital expenditures, which are necessary for maintaining and growing a company's asset base. This is crucial because it considers the cash required to sustain the business and invest in future growth. When it comes down to investment decisions then FCF is a better metric for evaluating a company's capacity to invest in growth initiatives, pay down debt, or return value to shareholders through dividends or share buybacks. Net Profit doesn't account for these uses of cash.

The companies that generate the highest Free Cash Flow (FCF) can vary from year to year and are often found in various industries, including technology, energy, healthcare, and consumer goods.

Here are some examples of companies that are expected to keep generating significant FCF:

• Apple Inc. (AAPL): Apple is known for consistently generating substantial FCF due to its strong sales of iPhones, iPads, Macs, and other products.
• Microsoft Corporation (MSFT): Microsoft's FCF is driven by its software and cloud services businesses, including Microsoft Office and Azure.
• Alphabet Inc. (GOOGL): Alphabet, the parent company of Google, generates substantial FCF from its dominant position in online advertising, search, and other digital services.
• com, Inc. (AMZN): Amazon is known for its strong FCF generation, driven by its cloud computing (Amazon Web Services) and other businesses.
• Arista Networks (ANET): The new and better Cisco, active in cloud infrastructure network switches, historically one of the largest FCF generators
• Meta Platforms (META): Global leader online advertising and online user engagement
• Nvidia (NVDA): Global leader AI GPU chips to power data centres, gaming

As shown above and contrary to 25 years ago, the highest FCF generators are now found in the Technology sector. Many years of solid FCF has allowed these tech companies to fortify their balance sheets, make add-on acquisitions, pay high dividends and execute large share buyback programs and hence providing a cushion in times of more (economic) uncertainty. High FCF can be an indicator of a company's potential for growth, but it is essential to consider the growth prospects and market conditions. Analysing the sustainability of a company's FCF is important. Rapidly declining FCF over time can signal operational or financial issues.

It is therefore that when we analyse the results of a company in our exponential tech universe, we always have a clear preference to digest many historic quarters & years of FCF generation in order to see what the main moving parts have been. By then extrapolating these elements forward one can get a pretty good picture of what a company should generate in incremental cash in the coming years, cash that it can use for many goals of which a few will be described below.

FCF is a valuable financial metric that can be used for various purposes within a company and by investors, analysts, and decision-makers. Here are some of the key uses of FCF:

1. Investment in Growth: FCF can be reinvested in the business for growth opportunities, such as expanding operations, launching new products or services, entering new markets, or acquiring other companies. It provides the capital needed to fund these initiatives without relying on external financing.
2. Debt Reduction: Companies can use FCF to pay down debt. Reducing debt levels can lower interest expenses, improve creditworthiness, and reduce financial risk.
3. Shareholder Returns:

• Dividends: Companies can use FCF to pay dividends to shareholders. This provides a direct return to investors.
• Share Buybacks: FCF can be used to repurchase company shares, which can enhance the value of remaining shares by reducing the number of outstanding shares. This benefits shareholders through capital appreciation.

4. Working Capital: FCF can be used to fund working capital needs, such as managing inventory, accounts receivable, and accounts payable. Maintaining adequate working capital is essential for day-to-day operations.
5. Capital Expenditures: A portion of FCF is typically allocated for capital expenditures, which include investments in property, plant, equipment, and technology infrastructure to maintain and expand the company's asset base.
6. Acquisitions and Mergers: FCF can be used for acquisitions or mergers, allowing a company to expand and diversify its business. Using cash for such transactions can provide flexibility and may avoid taking on additional debt.
7. Research and Development (R&D): FCF can be directed toward funding research and development efforts, enabling a company to innovate and stay competitive in its industry.
8. Divestitures: Companies may use FCF to divest non-core assets or business units, streamlining their operations and improving efficiency.
9. Liquidity and Financial Stability: FCF enhances a company's liquidity and financial stability, providing a financial cushion for unforeseen expenses or economic downturns.
10. Tax Obligations: Companies can use FCF to meet tax obligations, especially when they have tax liabilities that are not covered by Net Income.

 

Conclusion

In summary, while Net Profit is an important metric for understanding a company's profitability, FCF for us provides a more comprehensive and practical view of a company's financial health, its ability to generate cash and its potential for sustainable growth. When evaluating a company, it is often valuable to consider both metrics in conjunction, as they provide complementary information about its financial performance. Last but not least, FCF also provides a good tool to assess the valuation of a company through discounting future FCF’s to a net present value that can be compared to the latest share price. As a consequence it is one of our key methods to calculate if a particular share price has further upside potential or that it sufficiently valued vis-à-vis various investment alternatives.