The importance of Free Cash Flows

Author: Steven posted in Stock selection tagged with Cash flow statement, Investing 101

Free cash flows refers to the extra cash a company has generated and that can be shared with shareholders through dividends or can be reinvested in the company without harming the business operations. It is calculated by taking the operating cash flow and subtracting the capital expenditures (these values can be found in the cash flows statement).

Free cash flow = Operating Cash Flow – Capital Expenditures

A company can also use the free cash flows to repurchase the company shares which increases the value of the shares as there are less of them outstanding. However, in some cases the stock buyback can be a red flag for the investor.

Mature companies which generate a large amount of free cash flows tend to share the extra cash with the shareholders through high yield dividends. On the other hand, growth stocks tend to reinvest the extra cash in the business to fuel the company strategy for rapid growth, which can result in a potential future higher returns for the shareholders. It is also possible to have a negative free cash flow meaning that the company is spending more than it is earning. This can be seen in the initial years of company operations and although it involves a higher risk, it can lead to higher returns for the shareholders in the future.

By taking the free cash flow and dividing it by the sales value, you can calculate the free cash flow margin which provides a measure of how much free cash flow is generated from each dollar in revenue.

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