What it is
Operating cash flow minus capital expenditures. Whatever's left is "free" - available to return to shareholders (dividends, buybacks), pay down debt, or fund acquisitions.Why it matters more than reported earnings
Net income includes a lot of accounting estimates: depreciation schedules, deferred tax provisions, stock-based comp accrual, working capital changes. Free cash flow is what actually hit (or left) the company's bank account.A business reporting "$1B of net income" but generating "$200M of free cash flow" is hiding a problem. Either it's capitalising aggressively, accruing earnings it hasn't collected, or systematically under-reporting capex.
How to use it
- FCF / Net Income ratio: should be ≥ 80%. Lower = earnings quality concern.
- FCF Yield = Free Cash Flow / Market Cap. Compare to risk-free rate. > 5% is genuinely cheap.
- 5-year FCF growth: the cleanest growth signal - capital-light businesses can compound FCF faster than revenue
Pitfalls
- Stock-based compensation is a real cost but doesn't reduce FCF. Subtract SBC manually for true "owner" cash flow.
- Cyclical businesses have FCF that swings wildly year-to-year. Use 5-year average.