Understand free cash flow and FCF yield

Why Free Cash Flow Matters More Than Net Income

Accounting profit (Net Income) can be misleading because:

• Non-cash charges like depreciation reduce reported profit but don't touch the bank account
• Aggressive revenue recognition can inflate earnings before cash actually arrives
• Capital expenditures (buying equipment, buildings) are capitalized on the balance sheet, so the full cash outflow never appears in Net Income—only a slice (depreciation) shows up later

Free Cash Flow cuts through accounting games. It answers: "How much cash did the business actually generate that's available for discretionary use?"

WHY investors care:

1. Dividends and buybacks come from FCF, not accounting profit
2. Debt repayment requires cash, not earnings
3. Valuation: Companies are ultimately worth the cash they'll return to owners

Deriving Free Cash Flow From First Principles

Step 1: Start With Operating Cash Flow (OCF)

Operating Cash Flow = cash generated from core business operations (found on the Cash Flow Statement).

$\text{OCF} = \text{Net Income} + \text{Non-Cash Charges} + \text{Changes in Working Capital}$

WHY this step? Net Income includes non-cash expenses (depreciation) that reduce profit but don't drain cash. We add them back. We also adjust for changes in receivables/payables/inventory (working capital)—if inventory went up, cash went down.

Step 2: Subtract Capital Expenditures (CapEx)

Capital Expenditures (CapEx) = cash spent on long-term assets (factories, equipment, technology) to maintain and grow the business.

WHY subtract CapEx? This cash is not free—it's already committed to keeping the business running. If you don't maintain equipment, the business deteriorates.

The Formula

Alternative forms you'll see:

• Unlevered FCF (before debt payments) = FCFF = FCF to the Firm
• Levered FCF (after interest) = FCFE = FCF to Equity (what's left for shareholders)

We'll focus on Levered FCF (the cash available to equity holders after all obligations).

The FCF Yield Ratio: Turning FCF Into a Valuation Tool

Having FCF is great, but how much relative to the stock price?

WHY this ratio? It's the cash return you'd get if you owned the entire company. Think of it like a bond yield—higher is better (you're getting more cash per dollar invested).

HOW to interpret:

• FCF Yield > 5%: Generally attractive (company generates meaningful cash relative to its price)
• FCF Yield < 2%: Expensive (you're paying a lot for each dollar of cash generation)
• Negative FCF Yield: Company is burning cash (red flag unless it's a growth investment phase)

Compare to:

• Earnings Yield (E/P): FCF Yield is stricter because it accounts for CapEx
• Dividend Yield: FCF Yield shows what's possible; dividend yield shows what's paid

[!example] Example 1: Calculating FCF and FCF Yield for TechCorp

Given data for TechCorp (FY 2025):

• Net Income: ₹5,000 crore
• Depreciation & Amortization: ₹1,200 crore
• Change in Working Capital: -₹300 crore (inventory and receivables increased)
• Capital Expenditures: ₹2,500 crore
• Share Price: ₹800
• Shares Outstanding: 100 crore

Step 1: Calculate Operating Cash Flow

$\text{OCF} = \text{Net Income} + \text{Depreciation} + \text{WC Change}$ $\text{OCF} = 5{,}000 + 1{,}200 + (-300) = ₹5{,}900 \text{ crore}$

WHY this step? We're converting accounting profit to actual cash by adding back non-cash depreciation and adjusting for working capital (the -₹300 crore means cash was tied up in operations, reducing available cash).

Step 2: Subtract CapEx to Get FCF

$\text{FCF} = \text{OCF} - \text{CapEx}$ $\text{FCF} = 5{,}900 - 2{,}500 = ₹3{,}400 \text{ crore}$

WHY this step? We remove the ₹2,500 crore already committed to buying/upgrading equipment. The remaining₹3,400 crore is truly "free."

Step 3: Calculate Market Cap

$\text{Market Cap} = \text{Price} \times \text{Shares}$ $\text{Market Cap} = 800 \times 100 = ₹80{,}000 \text{ crore}$

Step 4: Calculate FCF Yield

$\text{FCF Yield} = \frac{\text{FCF}}{\text{Market Cap}} \times 100\% = \frac{3{,}400}{80{,}000} \times 100\% = 4.25\%$

Interpretation: For every ₹100 you invest in TechCorp, the company generates ₹4.25 in free cash. This is a moderate yield—not amazing, not terrible. You'd compare this to:

• Risk-free rate (government bonds ~7%)
• Industry peers
• Historical FCF yield for TechCorp

[!example] Example 2: Comparing Two Companies—RetailCo vs. GrowthStart

RetailCo (Mature Business):

• High FCF Yield (10%) = generates ₹10 for every ₹100 invested
• WHY? Established, low growth, minimal reinvestment needs
• Investor appeal: Cash cow, likely pays dividends, less risky
• Risk: Growth may be stagnant

GrowthStart (Tech Startup):

• Negative FCF (-1%) = burning ₹1 for every ₹100 market value
• WHY? Heavy CapEx investing infrastructure, chasing market share
• Investor appeal: High growth potential if it reaches profitability
• Risk: Could run out of cash, may need dilutive financing

The Lesson: FCF Yield isn't "higher = better" in isolation. Context matters:

• Value investors favor high FCF yield (RetailCo)
• Growth investors tolerate negative FCF temporarily (GrowthStart) if revenue is scaling

[!example] Example 3: FCF Yield vs. P/E Ratio—The Trap

Company: DebtHeavy Inc.

• Net Income: ₹1,000 crore (looks profitable!)
• Operating Cash Flow: ₹2,200 crore
• CapEx: ₹2,800 crore
• Free Cash Flow: ₹2,200 - ₹2,800 = -₹600 crore (burning cash!)
• Market Cap: ₹20,000 crore
• P/E Ratio: 20,000 / 1,000 = 20 (seems reasonable)
• FCF Yield: -600 / 20,000 = -3% (red flag!)

WHY the disconnect? Net Income only reflects depreciation (a slice of past CapEx), not the full ₹2,800 crore cash spent on new assets this year. The company looks profitable but is actually cash-flow negative because the heavy current CapEx never touched the income statement.

The Fix: Always check FCF. A low P/E can be a value trap if FCF is negative.

Common Mistakes (Steel-man the Wrong Idea)

[!recall]- Feynman Explanation (Explain to a 12-Year-Old)

Imagine you run a lemonade stand. At the end of the day, you count your money:

• You made ₹500 selling lemonade (revenue)
• You spent ₹200 on lemons, sugar, cups (costs)
• You also bought a new juicer for ₹150 (capital expenditure)

Your profit (net income) = ₹500 - ₹200 = ₹300. Great! (Notice: the juicer isn't subtracted here—accountants "spread" its cost over many days as a little "wear-and-tear" charge, not all at once.)

But wait—you actually spent ₹150 today on the juicer. So the actual cash in your pocket = ₹300 - ₹150 = ₹150. This is your free cash flow—the money you can use for whatever: buy candy, save for a bike, or expand your stand.

Now, if your friend wants to buy your lemonade stand for ₹3,000, the FCF Yield is ₹150 / ₹3,000 = 5%. Your friend is paying ₹3,000 to get ₹150 per year. Is that a good deal? Depends! If a savings account gives 7%, your stand is "expensive." If other stands only give 3%, yours is a bargain.

[!mnemonic] Remember FCF Yield

"Cash After Capex, Per Price Paid"

• Cash = Start with operating cash flow
• After Capex = Subtract capital expenditures
• Per Price Paid = Divide by market cap

Or: "FCF = OC - 💰Ex" (Operating Cash minus Money for Equipment)

Connections

• Cash Flow Statement: Where you find OCF and CapEx
• Price-to-Earnings Ratio (P/E): Compare FCF yield to earnings yield (inverse of P/E)
• Dividend Discount Model (DDM): FCF is the source of sustainable dividends
• Return on Invested Capital (ROIC): High FCF + high ROIC = great business
• Enterprise Value (EV): Use EV/FCF for capital-structure-neutral valuation
• Working Capital Management: Changes in WC directly affect OCF and FCF
• Capital Expenditure (CapEx) Analysis: Understanding maintenance vs. growth CapEx
• Discounted Cash Flow (DCF) Valuation: Projects future FCF to find intrinsic value
• Stock Buybacks: Funded by FCF; increases FCF per share
• Debt Service Coverage Ratio: FCF must cover debt obligations

#flashcards/stock-market

Concept Map

Hinglish (regional understanding)