Understanding Free Cash Flow

Welcome back, everybody. Today's challenge is about understanding free cash flow and the documents attached on the page. And if you open it up, you can see that for the background, we say free cash flow is a critical part of analyzing stocks. And for me personally, it's one of the most important criteria that I use, even more so than earnings. And the reason for this is that free cash flow gives a clear picture on a business's ability to fund its operations, invest for growth, pay off debt, distribute dividends or perform share buybacks. And then real quick, the calculation for free cash flow is simply cash from operations minus capital expenditures. And then many people also adjust free cash flow for stock based compensation, otherwise known as SBC. And SBC adjusted free cash flow is basically free cash flow, which you calculated above minus the stock based compensation. Now, there are some other ways to calculate free cash flow, which we'll see here in a minute that try to take into account things like other expenses and things that a business has to pay. In my opinion, it just gets a little bit too complicated in terms of, OK, well, which one is the right one? So we're going to use the most basic ones, because I think we can at least get the idea and then you can decide what works best for you. And we'll go through some examples here in a minute. But first, let's get to the action steps I want you to take before we come back together. Action step number one, pick two stocks in two different industries like technology and retail. Action step number two, calculate the trailing 12 month free cash flow for each company. You can find the data on the company's statement of cash flows or just about any investing website. In this example, I'm going to use Seeking Alpha because they have the data on the financials and cash flow tab. Action step three. Now calculate the stock based compensation adjusted free cash flow for each company. Stock based compensation is usually also shown on the cash flow statement. Action step number four. Next, calculate the free cash flow margin by dividing free cash flow by the trailing 12 month revenue for the company. The revenue can be found on the income statement. And then lastly, action step number five. Compare the free cash flow margin between the two companies. What does it tell you about their business? And then just a couple of things to think about, which we'll touch on at the end. How can earnings be more misleading than free cash flow? And then what is the issue when stock based compensation is a large part of a company's free cash flow? So go ahead and get started on your action steps right now. You can go ahead and pause the video and when you come back, we'll go through it together. I'll see you guys then. OK, we're back. So let's go through these action steps and see what we find. So first off, we'll start with Lowe's. And if we go to the cash flow statement, we can see that for the trailing 12 months, their cash from operations is ten point two nine six billion dollars. And as we know, that's the first number in the equation that we need. Now, the second number we need is capital expenditures. And if we scroll down just a little bit, we see the capital expenditures are right here. And if we do this quick math and basically take cash from operations minus capital expenditures, we get eight point three three billion dollars, which means that Lowe's free cash flow for the trailing 12 months is eight point three three billion dollars. And since we're here, we'll go ahead and calculate the stock based compensation adjusted free cash flow as well. And we can see that they have two hundred and six million dollars of stock based compensation. So if we take our previous number of eight point three three billion minus the two hundred and six million, we get eight point one two four billion dollars of free cash flow adjusted for stock based compensation. So the nice part is that it's pretty basic math. And so hopefully this is making sense. But let's look at Metta real quick. So now if we look at Metta and I go to the cash flow tab and I scroll down, I see cash from operations for the trailing 12 months is seventy eight point four billion dollars. And if we take a look at capital expenditures, it's twenty eight point eight billion dollars, which means that the free cash flow for Metta is forty nine point five four billion dollars for the trailing 12 months. And now if we want to do the stock based compensation adjusted number, we can see that Metta has a whopping 15 billion dollars of stock based compensation. And so if we subtract that from our free cash flow number, Metta's adjusted free cash flow for stock based compensation is thirty four point four four six billion dollars. So at first glance, we can see that Metta is obviously generating a lot more free cash flow than Lowe's is. But now we want to see what the actual free cash flow margin is. So comparing the free cash flow numbers to their actual revenues. So if we go back to Lowe's and we go to the income statement, we can see that their total revenue for the trailing 12 months is eighty five point three nine four billion dollars. And so if we take our free cash flow numbers and we'll just use the normal one at first, you take eight point three three billion divided by eighty five point three nine four billion. And you get a free cash flow margin of nine point seven five percent. Now, if you wanted to use a stock based compensation adjusted number, you would basically take eight point one two four billion and divided by eighty five point three nine four billion dollars. And you get a free cash flow margin of nine point five one percent adjusted for stock based compensation. So if we go to the income statement for Metta, we see that for the trailing 12 months, Metta has over one hundred and forty nine billion dollars of total revenue. So if we want to calculate the free cash flow margin for them, we basically take forty nine point five four billion dollars divided by one hundred and forty nine seven eighty four. And we get a 33 percent free cash flow margin. Now, if we want to take the stock based compensation adjusted number, then we take thirty four point four four six billion divided by the one forty nine seven eighty four. And we get a stock based compensation adjusted free cash flow margin of twenty three percent for Metta. So what does this actually mean? Right. So if we're comparing the two companies, clearly Metta has the higher free cash flow margin. And honestly, if you just think about their two businesses, it makes a lot of sense. Metta is a technology company. They work basically in digital advertising. That's the bulk of their revenue, if not almost all of it. Whereas Lowe's is a retail company. So they deal with a very capital intensive business that has lower margins because you're talking about actual retail sales in a store. And you can see the difference. If we go to the profitability tabs on Seeking Alpha, you can see that the levered free cash flow margin for Metta is twenty one point three seven. And if we go to Lowe's real quick, we can see that their free cash flow margin is seven point three. Now, the first question you may have is, wait a minute. Why is that different than what we calculated? And this comes back to what I said at the beginning, where there's different ways to calculate this, where in this case, what they took is the levered free cash flow per share, which also tries to account for other expenses that the business has. But at the end of the day, the exact number I don't think is important. It's more about understanding the ballpark that it's in and the trend of how that margin is either increasing or decreasing over time. Now, to compare Lowe's and Metta is really kind of unfair because they're two different businesses, right? It doesn't necessarily mean that one business is better than the other unless your strategy is to have highly profitable, high margin companies in your portfolio because you think over time they're going to do better. Now, for me personally, I tend to kind of trend that way in terms of the type of companies that I like to pick. But you don't have to. I mean, Lowe's has been an amazing performer for a very long time. All right, so let's go back to the two things that we were supposed to think about. So one, how can earnings be more misleading than free cash flow? And the main issue with earnings is that it includes a lot of non-cash items. So I think the best way to explain this is just with a simple example. Let's say that you own a small business and you provide services for somebody. And the way that it works is they pay you half up front and they pay you half whenever the job is done. So when the person walks in and says they want to hire you on that day in your accounting book, you're probably booking 100 percent of the sale. Because you actually secured a sale. But the cash flow that you get in your actual bank account is only 50 percent of that. Right. So let's say that your rent is due for the store that you're leasing to actually have a business presence. And it costs, you know, 80 percent of what that sale is. Well, your bank can only has 50 in it because you only got half of the money, even though you booked a sale that was 100 percent of the total revenue. So hopefully that makes sense. I probably confused it more than I needed to. But the point is, you can have earnings that don't necessarily reflect the actual money that's in your bank account. And so part of the reason why I like using cash flow more so than earnings is because I think it's a better indicator of financial health than good earnings is. Now, that doesn't mean that, you know, I won't look at earnings because I definitely will. But at the end of the day, free cash flow and cash flow generation to me is a very good indicator of a quality company. OK, now let's go to the last one. So what is the issue when stock based compensation is a large part of a company's free cash flow? And I think the best example of this that I've ever seen is actually Snap. And it's a company that I've talked about before that I was invested in like years ago and is one of the worst companies that I ever bought into. And I'm going to show you why right now. So if we go to Snap and we go to their financials and we go to their cash flow tab. So their cash from operations for the trailing 12 months was 244 million dollars, which was pretty close to what it was at the end of December as well. But then if we look at their stock based compensation, we see that it's one point two billion dollars, which is like five or six times what their cash from operations is. So what does that actually mean? Well, first off, if you actually calculated their free cash flow and you minus the capital expenditures, you would already only have like maybe 15 million dollars. But then if you account for stock based compensation, all of a sudden your free cash flow adjusted for SBC is now a minus one point one billion dollar plus negative number, which just from a math perspective means that they're technically not generating any free cash flow. And if we go to their income statement and we take a look at their shares outstanding, we can see why. Now, this shares outstanding graph is what I would call terrible. What it basically means is that Snap continues to issue new shares in order to reward employees, reward executives, and they're doing it at the expense of the shareholder because they're diluting the shareholders by issuing more shares every year. And that's exactly what this chart shows. Every single year, the shares outstanding keeps going up. Their stock based compensation keeps going up and it's way higher than even the cash flow that they're generating in the business. And so that's something that if you're a shareholder, you should be very mad at or quite frankly, you probably shouldn't be a shareholder because it means that the business isn't actually generating profits to benefit shareholders. They're basically just issuing new shares to benefit employees while the stock price has really done nothing over the last decade except for the artificial pump in 2020 and 2021. I mean, that is just a extremely ugly chart. All right. So that's it for this challenge. Hopefully it helped and you have a better understanding of what free cash flow is and how it can help you find really great companies to invest in. Now, if you have any questions, put them down in the comments below and I'll see you guys in the next one. Peace.