Judging a company’s free cash flow can be challenging, especially since it’s a monetary figure and not a ‘true’ metric per se.
One company may have £40 billion in free cash flow, and another may only have £10 billion. At the surface level, the company with £40 billion may seem like the superior investment, especially since shareholder rewards are paid from free cash flow.
But, digging a bit deeper, this may not be the case.
So, how do investors assess a company’s free cash flow?
First, let’s understand what it is and how it’s calculated.
What Is Free Cash Flow?
Free cash flow (FCF) represents a company’s residual cash after accounting for operating expenses (like wages and selling and distribution costs) and capital reinvestments (money spent on maintaining existing company assets or buying new ones).
Free cash flow highlights a company’s financial health by showing the funds available for business growth, debt reduction and shareholder rewards (dividends and share repurchases).
How Is It Calculated?
Free cash flow (FCF) is calculated directly from a company’s statement of cash flows.
In its simplest form, the free cash flow formula is as follows.
FCF = Net Cash From Operating Activities – Capital Expenditure (CapEx)
For a more in-depth overview of free cash flow, click here.
How Investors Assess Free Cash Flow (Mastercard Example)
Because free cash flow is a figure, investors use various financial ratios and metrics to analyse it. When assessing free cash flow, investors often ask:
- Is it growing?
- How fast is it growing on a per-share basis?
- How much revenue is being converted to free cash flow?
To illustrate how investors answer these questions, we’ll use 5-year financial data from Mastercard – one of the world’s largest payment processing companies.
Mastercard’s 5-Year Financial Data ($ in millions, shares in millions)
| 2015 | 2016 | 2017 | 2018 | 2019 | |
| Free Cash Flow | $3,924 | $4,422 | $5,364 | $5,893 | $7,761 |
| Revenue | $9,667 | $10,776 | $12,497 | $14,950 | $16,883 |
| Market Capitalisation | $168,818 | $195,588 | $241,634 | $336,506 | $376,363 |
| Shares Outstanding | 1,137 | 1,101 | 1,072 | 1,047 | 1,022 |
Free Cash Flow Growth
Calculated using the formula below, free cash flow growth helps investors assess how fast a company grew in the past and how fast it is likely to grow in the future.
FCF Growth = (This Year’s FCF / Last Year’s FCF) – 1
Using that formula, Mastercard’s annual free cash flow growth is as follows.
| 2015 | 2016 | 2017 | 2018 | 2019 | |
| Free Cash Flow | 3,924 | 4,422 | 5,364 | 5,893 | 7,761 |
| Free Cash Flow Growth | 13% | 21% | 10% | 32% |
Mastercard consistently achieved double-digit free cash flow growth throughout the period – a sign of a thriving company. If we annualise the increase from 2015 to 2019, Mastercard grew its free cash flow by 19% annually.
The annualised rate, or the compounded annual growth rate (CAGR), gives investors a company’s average annual growth rate over a given period.
Why Investors Look At Free Cash Flow Growth
Investors look at free cash flow growth because it is central to the valuation process.
Companies are valued based on their expected future free cash flows. Therefore, the faster a company grows its free cash flows, the more valuable the company. The more valuable a company is, the higher its stock price.
Investors also look at free cash flow growth because it drives shareholder value. Consistently growing free cash flows increase the funds available to pay dividends to shareholders and repurchase shares.
Dividends are distributions made to shareholders out of a company’s profits.
Share repurchases reward shareholders by increasing their ownership stake without buying additional shares. If a company has ten shares outstanding and you own two, you have a 20% ownership stake (2/10). If the company buys back two shares, you now have a 25% ownership stake (2/8) without buying any additional shares.
Free Cash Flow Per Share Growth
Alongside general free cash flow growth, investors like to view and assess growth on a per-share basis.
Free cash flow per share tells investors how much free cash flow is allocated to each share of a company’s stock. It is calculated using the formula below.
FCF Per Share = Total Free Cash Flow / Total Shares Outstanding
Free cash flow per share growth is then calculated by dividing the current year’s free cash flow per share by the prior year’s and subtracting 1:
FCF Per Share Growth = (This Year’s FCF Per Share / Last Year’s FCF Per Share) – 1
Using these two formulas, Mastercard’s free cash flow per share and free cash flow per share growth are as follows.
| 2015 | 2016 | 2017 | 2018 | 2019 | |
| Free Cash Flow Per Share | $3.45 | $4.02 | $5.00 | $5.63 | $7.59 |
| Free Cash Flow Per Share Growth | 16% | 25% | 12% | 35% |
Over the five years, Mastercard experienced, on average, high double-digit growth. If we annualise the growth from 2015 to 2019, Mastercard grew its free cash flow per share by 22% annually.
Keen eyes will notice that Mastercard’s free cash flow per share (22%) grew faster than its total free cash flow (19%). This is due to the company repurchasing its shares (a concept explained in the following section).
Why Investors Look At Free Cash Flow Per Share Growth
Investors look at this metric to assess:
- How fast a company’s free cash flow is growing on a per-share basis
- The impacts of a company’s share repurchases on its per-share growth
Free cash flow per share growth is important to investors because they own shares in a company, not the whole company. Investors like high free cash flow per share growth because their shares yield more free cash flow with each passing year, and this high growth makes the company more valuable.
However, because it incorporates a company’s total outstanding shares, free cash flow growth and free cash flow per share growth often differ.
Take Mastercard, for example.
| 2016 | 2017 | 2018 | 2019 | |
| Free Cash Flow Growth | 13% | 21% | 10% | 32% |
| Free Cash Flow Per Share Growth | 16% | 25% | 12% | 35% |
| % Reduction in Shares Outstanding | -3% | -3% | -2% | -2% |
You can see that Mastercard’s free cash flow and free cash flow per share growth rates are different each year. This is due to the company’s share repurchases (the annual percentage reduction in total shares outstanding).
Because total shares outstanding are in the denominator of the free cash flow per share formula, when a company conducts share repurchases, the reduced number of shares boosts free cash flow per share. Therefore, the difference in free cash flow growth and free cash flow per share growth is explained by the annual change in a company’s total shares outstanding.
If you sum the percentage reduction in shares outstanding and the free cash flow per share growth, it should equal the free cash flow growth. Some won’t work out because the percentages are rounded.
n.b.
A company’s free cash flow per share and all other per-share metrics can be easily manipulated by simply buying back shares. So, it’s crucial to check that the company is buying back shares to reward shareholders…not to prop up per-share metrics.
Free Cash Flow Margin
Free cash flow margin, expressed as a percentage, tells investors what percentage of a company’s total revenue is converted to free cash flow. Calculated by dividing free cash flow by revenue, the higher the margin, the more revenue a company converts to free cash flow.
FCF Margin = Free Cash Flow / Revenue
Using that formula, here’s Mastercard’s free cash flow margin trend.
| 2015 | 2016 | 2017 | 2018 | 2019 | |
| Free Cash Flow Margin | 41% | 41% | 43% | 39% | 46% |
Over the five years, Mastercard experienced an overall upward margin trend (margin expansion, as the pros call it) — a trait that makes any company more valuable.
In 2015, Mastercard generated $41 in free cash flow for every $100 it received in revenue. By 2019, the company generated $46 in free cash flow for every $100 in revenue. This may not seem like a huge difference, but it is. This difference represents a 13% increase in operating efficiency. In other words, Mastercard converted 13% more revenue to free cash flow in 2019 than in 2015.
Why Investors Look At Free Cash Flow Margin
Alongside growing free cash flow and free cash flow per share, investors are attracted to companies with high free cash flow margins.
Since shareholders are rewarded from a company’s free cash flow, the higher the margin, the more attractive the company. In other words, the more revenue a company converts to free cash flow, the more dividends it can distribute and the more shares it can repurchase.
What is considered a high free cash flow margin is subjective and varies from investor to investor. But converting almost half your revenue to free cash flow is pretty exceptional.
Summary
Free cash flow (FCF) is one of the most powerful figures for understanding a company’s long-term potential. By focusing on it, investors get insights into the cash a business generates beyond its operational and capital needs—cash that fuels growth, pays dividends, and repurchases shares.
Calculating free cash flow is straightforward, but its true value lies in how it’s assessed and what it says about a company.
Consistent free cash flow growth signals strong business performance, leading to higher potential company valuations. High free cash flow per share growth highlights significant shareholder value creation, and free cash flow margin tells how effectively a company converts its revenue into cash.
Together, these metrics help investors separate fundamentally sound businesses from those with shaky financial foundations. Armed with these insights, investors can make more informed decisions and better identify businesses with enduring value.
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