What is Free Cash Flow and Why it is Important for Business?4 min read
Free Cash Flow or FCF is a commonly used term for any business. FCF is also an important factor for many of the stocks which compounded massively in the past. Free Cash Flow is very important for a business because it indicates several prospects for the company. So, let’s discuss what are FCF, how is related to earnings growth, with examples in this article as we move ahead.
What is Free Cash Flow?
- Free Cash Flows are operating cash flows of the company after adding back after-tax interest from which capital expenditures are subtracted.
- The value of the company is the net present value of all the future free cash flows that the company earns. A high quantum and growth of these free cash flows on a sustained basis makes the company a cash-generating machine that churns out cash every year.This is a very desirable quality in a company from the investor’s point of view.
What is Earnings Growth:
- Earnings growth is determined by the pricing powerthat the company commands. In addition, factors like operating efficiencies also help in increasing the earnings growth of the company.
- Over time, once a company manages to create a moat in a segment, the revenues and earnings might begin to stagnate. Companies need to understand when they can deploy their cash earned (pivot)from a business of its moat into other verticals to keep growing the top line and bottom.
Free Cash Flow and Earnings Growth:
- From the above picture, the firm with high FCF and high Earnings growth is proven to be efficient compounders, while a firm with low FCF and Low Earnings growth is considered to be a laggard.
- A company which is having high FCF but low earnings growth falls under the category of declining stars means with low growth prospects. Companies that have low FCF and high earnings growth potential.
Example of Efficient Compounder: Asian Paints:
- From the above graph, it is apparent that the company has grown its free cash flows and profits efficiently.
- Low free cash flows do not necessarily mean that the company is weak.
- During certain years of the company when the company is trying to expand, high capital expenditures will affect free cash flows but this generally results in high free cash flows once the Capex cycle is over.
- Between FY17 to FY19, the free cash flows seem to stagnate since the company was doing Capex for further expansion and the result of which is seen in FY20 and FY21.
- What worked for Asian Paints?
- Asian Paints has made good capital allocation decisions in terms of expanding to new geographies, setting up new plants at strategic points in time, and constantly making technological improvements.
- Asian Paints is always known for innovation in their product. They have managed to ward off competition by being ahead of their peers in a competitive market.
- They have managed to maintain good business relationships which have enabled them to achieve excellent supply chain management, have an excellent dealer and distributor relationships, and created brand loyalty with the customers.
Example of Declining Stars: Bajaj Auto:
- As is apparent from the graph, the free cash flow and profit numbers have hardly seen a growth. The company can generate good amounts of free cash flows every year but the re-investment of those cash flows is not translating into increased profits.
- One major reason for this in the case of Bajaj Auto has been the slowdown in the automobile sectorwhich started around 3-4 years ago when sales across the industry started stagnating. To add to it, Covid did not make the matter easier. However, in the last few years, the company has fallen back in terms of innovations and capturing incremental market share compared to its peers. It also was not an early adopter of EVs (Electric Vehicles) which is a clear theme in the auto industry going forward.
- The result of not being able to achieve growth has also been reflected in the share price of the company which has given a mere 10% CAGR returns in the last 10 years.
Example of Emerging Compounders: Dixon Technologies:
- Dixon Technologies has an impressive rate of growth in profits. However, going by the free cash flows, the numbers are not very impressive. This is because, in recent years, the company has concentrated on trying to ramp up its capacity.
- Dixon is into contract manufacturing of electronic products and this has seen immense growth in recent years.
- Taking stock of expected demand and market penetration they could do in the future, the company did a lot of Capex and expects the revenues and profits to grow further.
Example of Laggards: Apollo Tyres:
- Apollo Tyres is seeing a consistent decline in its profits for several years now. To add to it, Capex does not seem to help in increasing the revenues and profits yet.
- Apollo Tyres has been operating at a high capacity utilization for several years and was due for a Capex cycle. However, the macroeconomic factors in the automobile industry have not been favorable for the company. This, coupled with dominant peers emerging has left very little pricing power with the company.
- In absence of pricing power, it is difficult to achieve growth in profits.
What Should Investors Do?
Free Cash Flow (FCF) is an important financial parameter to look at in the company while investing along with earnings growth available in the sector as well as for the company. For better compounding, an investor should look for companies with high FCF and high earnings growth
Disclaimer: The information here is provided for reference purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent are commendation to buy or sell stocks or MF.