Moat Investor

Free Cash Flow

Free Cash Flow (FCF) is a measure of financial performance calculated as operating cash flow less capital expenditures. That means that FCF is the cash left over after a company has reinvested in its capital assets.

Why is FCF important to Moat Investors? First, FCF is one of the best measures of a company’s health. Looking at their FCF is like taking their temperature – are the sick or healthy? FCF makes a company more agile, giving them the ability to respond to new opportunities that contribute to shareholder value (e.g., acquisitions that support growth, new R&D, dividend payouts and debt reduction). It’s just like your life – if you have enough to pay your bills and rent, you’re doing OK. If you don’t have enough, you’re in trouble. If you have enough cash that you can pay the bills and invest some more into companies with great moats, then you’re in great financial condition.

What about earnings? Earnings are important, but clever (or unfortunately, even unscrupulous) companies can find ways to boost earnings in the short term. It’s hard to phony-up your FCF. Think about it this way. If you were going to buy a company (isn’t that what you’re doing, after all, when you invest in a company’s stock), you would look at a couple of big areas, liquidation value and FCF. Let’s say you were going to buy a restaurant. You might buy a failing restaurant for $400k because you knew you could sell the furniture and equipment for $500k. But if the restaurant was a success and was spinning off $500k a year to its owners, you would probably be willing to pay more like $2m for the right to those future cash flows. Like Warren Buffet says, “Cash is King.”

What if the company I love has negative cash flows? Dig a little deeper. If the company you love really fits the Moat Investor Philosophy (e.g., great moat, consistent performance and ROE, great management, etc.), it is likely that the negative cash flow is due to investing in other areas. Maybe they are upping their brand marketing or opening new stores that will translate into even more revenue down the road. That said, companies with small or negative cash flows may have to boost their debt positions for expansion and new growth opportunities, so keep a close eye on FCF and levels of debt.

There are of course ways for companies to pump up their FCF, especially in the short term – better debt or payment terms, depleting inventory, layoffs, plant closures – but none of these have the affect on future growth that you should be interested in. The worst companies can play with their revenue recognition to make their Accounts Receivable look like cash. But as a Moat Investor, you know and trust their management team, so you wouldn’t invest in one of those companies, would you?