What is Free Cash Flow?

hi guys I'm Phil town its rule 1 investing time we're going to talk about free cash flow today now free cash flow is incredibly important to a rule one investor this is probably the most critical thing we can look at and interestingly it's not a number you can come up with very easily it's not part of generally accepted accounting principles so companies when they form their financial statements don't have a line on there for free cash flow and yet this is a number you've got to know before you go out there and you buy companies because free cash flow is what you would actually get back in your pocket if you own the whole company and you get to collect the money ok so let me give an example let's say you own a laundromat and you're going to have to replace washing machines from time to time so what happens is you get in all this money and then you got to pay off this money to replace the machines and stay in business now what you've got left after you pay your employees pay for the new washing machines pay for all your detergent clean the place pay for your rent what you've got left after you replace everything you need to do to stay in business what you've got left is free cash flow now interestingly there are lots of businesses that have really good earnings they've got net earnings but they don't have any free cash flow they chew up all of their earnings just to stay in business because they've got to go rebuild their plant they got to go put stuff back that they burned up in fact the car companies are really good examples of companies there have a lot of trouble getting free cash flow because why because they constantly have to put in new moles that council got anymore our ID constant got to build the next model you destroy the old model they got to build new warehouses they got to build new plants and all of that sucks up free cash flow now free cash flow is hugely important for two reasons the first is that's the money we'd get if we own the whole company that we can then go allocate anywhere we want and second it's the money that the company can allocate where it wants as well so how do we get or what's our best way to look at free cash flow is first off to find out is there is there any and second to understand what the companies doing with it so how do we figure this out real simple you look at the cash flow statement okay free cash flow comes off the cash flow statement in a real simple piece of math you take the on the cash flow statement you look and there's a line there usually in bold that says operating cash flow or cash flow from operations all right take that line you'll notice it's different than the net income which is usually the top line of the free cash flow or top line of the cash flow statement you take that line cash flow from operations and you subtract from it the purchase of property and equipment line which is just down below it a few lines so let's say that operating cash flow or cash flow from operations is a million dollars and this company has $100 that it has to pay out in terms of property and equipment so what that means is we've got a million dollars coming in in cash flow and we're only paying out a hundred dollars to actually stay in business so we end up with nine hundred ninety nine thousand dollars and some change that we get to go out and do anything we want with we can take it as an owner allocated to other businesses we can put it back in the company to grow the company that would be a company that has awesome free cash flow now same example the company's got a million dollars of cash flow from operations but it's spending nine hundred ninety thousand dollars on property plant and equipment in other words replacing stuff to stay in business in which case we only have ten thousand dollars of free cash flow and all of a sudden our investment doesn't look as good as when we look at just the net earnings now what happens with Berkshire Hathaway is that Warren Buffett built a company that is a cash flow monster he's bought all of these little companies that are private companies or public companies that produce dividends and that money comes in in the form of free cash flow right up to Berkshire for Buffett to reinvest in other things we want to be able to do exactly the same thing we want free cash flow to come unto us from our companies now the thing is we don't own the whole company so we're going to free cash flow allocated to us in one of three ways number one way and probably the favorite way is this company takes the free cash flow and reinvest it and grows that business faster we love that that's an awesome way to use free cash flow the second way is that they pay us dividends which are okay we got to pay taxes on that if we're not doing this inside of a tax protected account like a Roth IRA or an IRA so we have to pay some taxes but at least we get the cash flow and we can reallocate it then the third way is way cool if they do it right and that is they buy back their own stock with that free cash flow now we only want them to do those buybacks and this is real important when that stock is cheaper than the intrinsic value of the company or what we call the sticker price so if they're buying back stock at a price that's cheaper than sticker then that is accruing value to us as a shareholder we're gaining more value of the company than we're losing by paying out the cash flow if they're buying it at higher than the sticker that's a no-no they're basically taking money right out of our pocket so those three ways they're either reinvesting it and it's going to grow the company faster than it would otherwise second they pay out in dividends or third they buy back the stock but they got to do it right so look at free cash flow make sure it's this is what I'm looking for that free cash flow is at least the size of the net earnings if it's not make sure you're not paying too much for that company all right you guys that's about it on free cash flow if you like what you've seen here then subscribe to my channel for more content okay I'm fill town and it's time to go play

Channel: Rule #1 Investing

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Id: xxQcdk2LvbA

Length: 6min 3sec (363 seconds)

Published: Thu Jan 14 2016