What's Wrong With Free Cash Flow
Cash is king, right? The net present value of projected free cash flow is the ultimate measure of value creation. We often hear that, at the end of the day, cash flow is all that matters--and it's true. So, with cash flow being so kingly and all, what could possibly go wrong with focusing on that metric in evaluating our management?
What FCF is missingLike a four-stroke engine taking in and expelling gas, whether or not cash inflow or outflow is creating value depends on what happens in the second and third phases of the cash flow cycle.
In the first phase, cash coming in from investors (cash from financing) counts as positive free cash flow. But this transaction is value neutral for the company as long as the cash sits waiting to be deployed. In the second phase, when the company makes an investment, it is experiencing negative free cash flow. But by exchanging one asset (cash) for another (presumably productive assets), it may be creating significant value--or not. We find out in the third phase, when we (hopefully) receive cash from operations. This positive free cash flow provides clear evidence of value creation to the extent that the returns exceed the cost of capital. Finally, payments to investors via interest, dividends, share repurchases, etc. are negative free cash flow for the company, but simply transfer cash from its coffers to the shareholder's pockets.
In other words, there are abundant instances when negative free cash flow may be value enhancing, and when positive free cash flow is not. For most of its first 20 years as a public company, WalMart was investing more in new stores than it was earning from its existing stores, resulting in a growing, negative free cash flow year after year. But all of that outflow was building assets of greater value than the cash being invested, growing them into one of the world's most valuable companies. When it works Free cash flow is the right measure when you have no investments left to make, and your strategy is to liquidate your assets in a reasonably short period.
