Free cash flow is the cash a company has left over after paying its expenses, interest, taxes, and reinvesting in the business. It’s used to buy back stocks, pay dividends, or participate in mergers and acquisitions. It also arguably provides a more comprehensive and accurate snapshot of a company’s potential profitability.
“Free Cash Flow measures profitability based on the cash flow the business is generating versus metrics like earnings that are reliant on accounting assumptions,” said Michael Mack, Associate Portfolio Manager, VictoryShares and Solutions. “We believe it’s ultimately what matters.”
And what is one major benefit to a free cash flow investment strategy? It equalizes the playing field for companies given that other valuation metrics may fail to account for the intangible assets the company has invested in. Price to book is a good example of this, measuring only tangible assets. Free cash flow is a valuation metric that captures both.
Tangible Vs. Intangible Assets
Tangible assets are physical items that a company owns, like buildings, land, equipment, or inventory. Intangible assets, meanwhile, are items that don’t physically exist, like intellectual property, research and development, patents, or brand development. For example, Apple derives much of its value from its design efforts and IP, not necessarily from its manufacturing.
Companies that invest in physical assets are often considered to have a higher value than those that invest in intangibles. But we believe that idea is misleading since intangible assets may represent potential future revenue.
Dynamics have shifted over the past 30 years when companies had been more asset heavy; whereas now, many of the largest companies have an array of intangible assets. In fact, those companies that put their money into intangible assets tend to grow more.1
The Rewards of the Intangible
Intangible assets can be hard to quantify. They may not have an immediate impact on free cash flow the way tangible assets do. However, over the long-term, companies that invested wisely in intangible assets are likely to have been rewarded.1
“Free cash flow allows investors to level the playing field and gain a more accurate assessment of a company’s overall assets, whereas traditional accounting metrics, such as earnings and book value, have punished companies that invest heavily in R&D”2, Mack said.
Free cash flow can help one assess the overall financial performance and value creation of companies, regardless of whether they primarily invest in tangible or intangible assets. By measuring the cash generated from operations minus capital expenditures, free cash flow gives a clear picture of a company’s potential to generate surplus cash that can be reinvested or returned to shareholders.
For more news, information, and analysis, visit the Free Cash Flow Channel.
1/ Hazan, Eric, et al. “Getting Tangible About Intangibles: The future of growth and productivity?” McKinsey Global Institute Discussion Paper (June 2021)
2/ Xu, Lianzan and Cai, Francis, “Value Relevance of Earnings, Book Value, Revenue, and R&D” Cambridge Business Review (2016)
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The opinions are as of the date noted and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.
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