Free cash flow (FCF) is the cash that is available to all investors, whether debt holders or shareholders, after taxes have been paid. This is the after-tax cash flow that would be earned if a business was entirely equity financed. Consequently, it is not only free from non-operating items, but from items related to capital structure as well. When John Burr Williams developed the theory of DCF analysis in his ground-breaking book, The Theory of Investment Value, he assumed that intrinsic value was a function of dividend flows and selling price, and that under certainty, the value of a business was the sum of its future dividends. (This idea would lead to Myron J. Gordon’s dividend discount model.) Therefore, one can view FCF as what a company could pay in the form of dividends. It can be defined as,
FCF = NOPAT – Change in Invested Capital
where change in invested capital is
Change in Invested Capital = Change in Net Working Capital + Change in Total Adjusted Fixed Assets
The level of available FCF must be assessed against the growth opportunities available for the business, in order to make a definitive determination about the quality of that FCF.
Below is my calculation of Diamond Hill’s FCF for the period 2019 to the last twelve months (LTM) ending 2Q 2024:
If the purpose of an investor is to buy assets whose price implies low expectations and sell those assets whose price implies high expectations, then the question one should ask here is, “What are the market’s FCF expectations?” This cab be ascertained by calculating the FCF yield:
FCF Yield = FCF/Enterprise Value
Where enterprise value is the value of a business for all its sources of financing. The FCF Yield is ranked according to the risk/reward rating below: