In valuing a stock, many investors simply look at earnings per share or, at the most, net income, and think they’re done. I think that’s a mistake. Investors, especially dividend investors, should pay close attention to free cash flow, or FCF, too. Why? For one, free cash flow is harder to “tinker with” than net income.
But I think it’s even more important than that. Often times, the best investment opportunities are the sharpest allocators of capital: companies that are disciplined and put pressure on their money to perform. In this article I’m going to explain why free cash flow is an important piece of this puzzle and give three examples of companies practicing this.
Here’s how to find free cash flow: It is operating cash flow less capital expenditures, or CapEx. So, free cash flow is usually what’s left after a company pays for its expenses as well as expenditures for growth.
Nothing wrong with growth, but …
When a company spends money on any project, it is putting capital to work and expecting to get a return. CapEx is usually what is spent to grow a business. But as a business matures, growth becomes increasingly expensive and the return on each dollar spent goes down. Ever hear the term “growth for growth’s sake?” It’s almost never a good thing.
Management that knows how to say no to this urge are an investor’s best friend. As investors we want a management team that puts a stop to spending that does not provide a good return.
So how does FCF fit into this equation? When a company says no to a growth project, generally the would-be CapEx becomes free cash flow. Companies with high FCF versus CapEx sometimes have few growth prospects. Or they may have growth prospects, but are disciplined and choose only the best projects for capital allocation. We want the latter.
Here are some examples
Last quarter the company raised an astonishing .23 cents of FCF for every revenue dollar. Core Laboratories N.V. (NYSE:CLB) managed to grow net income by 12% despite FCF being over six times CapEx!
So, free cash flow numbers are great, but how do you think Core Laboratories N.V. (NYSE:CLB)’ return on invested capital, or ROIC, is like? If you guessed ROIC is also on top, you’d be right. And that’s no coincidence. When a company puts a premium on free cash flow, it acts as a sort of competitor against CapEx – only the best CapEx projects are allowed over free cash flow. Core Laboratories N.V. (NYSE:CLB) is the best example of this and it is why its ROIC is as high as it is.