Free Cash Flow

Many investors tend to use a company’s earnings to evaluate performance, but net income can easily be distorted by accounting gimmicks. Free cash flow, on the other hand, is difficult to fake (though not impossible) and provides a more transparent view of a company’s ability to generate cash and profits.

Free cash flow is the cash left over after a company meets its necessary expenses. A company can reinvest their free cash to grow its own business and, in turn, boost shareholder returns. Alternatively, free cash flow can be returned to shareholders through bigger dividend payments or share buybacks.

There are many ways to use free cash flow in a company analysis. I will use beverage giant Coca-Cola (KO), which is a great example of a company that consistently generates high free cash flows, which often exceed its reported net income – a sign of high earnings quality.

Free cash flow to Revenue
In 2008, Coca-Cola produced $5.6 billion in free cash flow from $31.9 billion revenues. Thus, Coca-Cola’s free cash flow to revenue ratio was an impressive 16.6 percent – a good rule of thumb is to look for companies with free cash flow that is more than 10 percent of sales revenue.

Free cash flow multiples
It is also important to look at free cash flow multiples. Free cash flow yield allows you to compare how much cash power the share price buys, or how much investors pay for one dollar of free cash flow. Price to free cash flow is similar to the more commonly known price/earnings (P/E) ratio.

Comparing Coca-Cola to direct competitor Pepsi Co. using these multiples suggests that Coca-Cola is reasonably priced.

Efficiency Ratios
Besides looking for low free cash flow multiples, we also seek out attractive efficiency ratios. An attractive Return on Equity (ROE) can help ensure that the company is reinvesting its cash at a high rate of return.

On this front, Coca-Cola performed exceedingly well with a ROE of nearly 26%. In other words, Coca-Cola was able to generate 26 cents worth of profits from each dollar invested by shareholders.

To double check that the company is not using debt leverage to give ROE an artificial boost, we also examine Return on Assets (ROA).

A ROA higher than 5% is normally considered to be solid for most companies. Coca-Cola has an impressive 12.6 % ROA, which should reassure investors that the company is doing a good job of reinvesting its free cash flow.

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Peter J. Lazaroff