Following your enthusiastic responses to yesterday's post on capital expenditures and R&D - another leak especially for you straight from the editorial desk of the Hot Stocks Alerts team.
A stock market concept in 60 seconds.
What is Free Cash Flow and why is it more important than net income?
Spoiler: Warren Buffett doesn't start investing before checking this number.
Net income is like seeing a picture on Instagram with a filter.
It looks good, but that doesn't mean it's reality.
Net income is what a company reports after all its revenues and expenses, including taxes, depreciation, and other accounting expenses.
But it doesn't always reflect the actual amount of cash the company holds.
And here enters Free Cash Flow (FCF): the true king of the financial world.
So what exactly is FCF?
Free Cash Flow = cash from operating activities minus capital expenditures (CapEx).
Meaning: how much real money is left for the company after it has paid for everything, from coffee in the kitchenette to production machines, salaries, investments, maintenance, and infrastructure.
With free cash, a company can: distribute dividends, invest in growth or acquisitions, execute buybacks (repurchase its own shares), reduce debt, or simply put it aside for a rainy day.
Real-world example: Apple
Apple reports a net income of $100 billion per year.
But that doesn't mean it actually has $100 billion for immediate use.
After huge expenses on research, chip manufacturing, store openings, contracts with suppliers, its FCF (as of recent years) stands at $90-95 billion.
And this is a huge figure, which explains how it can both distribute dividends and buy back shares in enormous volumes.
Why is this important for us as investors?
Because net income can be 'played with' using accounting tricks. But FCF is hard to fake – it's about cash that actually enters and leaves the company's coffers.
Companies with positive and growing FCF over time = healthy, profitable companies that can grow and return value to shareholders.
When examining stocks, it's sometimes hard to understand why investors love them so much, but when you overlay the stock chart on the FCF growth chart, you suddenly see a precise match
- as in the example above of Spotify
Tip for smart investors:
Add an FCF column to your tracking table.
And remember that in companies with high net income but negative FCF, a risk may be hidden.