In an ideal company, free cash will keep increasing by a predictable amount. If you compare the expected cash flow trend to the measured free cash flow, you'd see a straight line, up and to the right.
Not even the best companies can do that—nor should they be expected to. Sometimes it makes sense to increase business investments one year, investing free cash now to make more money later. Other times, circumstances beyond the business's control mean they make more or less money than expected.
You can't expect perfect predictability from any business (otherwise it's a good sign someone's scamming you), but you can identify solid companies with consistent histories. Consistent profitability is a very good sign.
How to Calculate Free Cash Flow
Free cash flow is a measurement of the amount of money a business has from which to reinvest or to pay its shareholders every year.
To calculate free cash flow, you need to look at the business's reported annual SEC filings. The business will report its earnings. Look at the earnings before interest and taxes. Next, look at any reported depreciations. Because depreciating capital expenses is a means to reduce taxes by reducing the taxable amount of earnings, you need to add back in any depreciation. Then subtract out the taxes paid.
This gives you an interesting number: it's the amount of real money the company actually produced. It's not money on paper and it's not money according to accounting principles. It's actual cash received. Now subtract the amount of money necessary to keep the business's equipment and everything running properly—routine maintenance of its factory, for example.
The result is more accurate than earnings. It's the amount of cash the business has generated above and beyond what it needs merely to stay in business. It's the amount of money the business can pay to shareholders as dividends, buy back existing shares of stock, buy other companies, or otherwise invest in expanding. It's the reason the company is in business.
Free cash flow is probably the most important value investing measurement.
What is Free Cash Flow Jitter?
Free cash flow jitter is a measurement of the degree to which actual free cash flow differs from expected. It measures two things at once: the accuracy of free cash flow projections and the efficiency of the business over time. You might even say that it's a measurement of how boring the FCF is (and what's better than a profitable, boring company on sale?).
How well do the peaks and valleys of the measured free cash flow fit the trend line? A small value for jitter, perhaps anything under 20%, is excellent. Anything under 40% is good. Anything over than that is information to keep in mind.
The effects of jitter are obvious when you look at a free cash flow projection graph:
FCF Jitter Measures Efficiency and Predictability
Remember that before you invest, you need to know the company's story. Can it really produce the expected profits in the coming years? Keep the predictability of its past free cash flow in mind as you consider what it might do in the future. The less jitter, the more the company meets your predictions. If your predictions meet your investment targets (such as the present value of what you want the investment to be), then you may have found a fantastic investment.
Great companies have boring, predictable cash flow trends. That's why they're great.
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