Why Cash Flow Matters More Than Earnings
Reported earnings (net income) are an accounting construct. They include non-cash items like depreciation, amortization, and stock-based compensation. Free cash flow (FCF) measures actual cash generation:
FCF = Operating Cash Flow - Capital Expenditures
A company can report positive earnings while burning cash (through working capital expansion, heavy capex, or aggressive revenue recognition). FCF cuts through the accounting noise.
What FCF Tells You
Free cash flow is the cash available to the company after maintaining or expanding its asset base. This cash can be used for dividends, share buybacks, debt repayment, acquisitions, or reinvestment in the business.
Consistently positive and growing FCF indicates a healthy, self-funding business. Persistently negative FCF means the company relies on external financing (debt or equity issuance) to fund operations.
FCF Yield
FCF Yield = Free Cash Flow / Market Capitalization
This ratio normalizes FCF by company size, making it comparable across companies. A higher FCF yield suggests better value — the company generates more cash relative to its price. Some investors use FCF yield as an alternative to earnings yield (the inverse of P/E) for valuation.
A FCF yield above 5-8% is generally considered attractive, though this varies by growth expectations and industry.
FCF Limitations
FCF can be manipulated through capex timing: delaying necessary maintenance spending temporarily inflates FCF. Companies in heavy growth phases may have negative FCF by design, as they invest aggressively in future capacity.
Always examine the trend over multiple years rather than a single quarter. The Apter Quality factor looks at FCF consistency and conversion (the ratio of FCF to net income) to distinguish genuine cash generation from accounting artifacts.