- 1Free cash flow = operating cash flow minus capital expenditures
- 2FCF is harder to manipulate than accounting earnings
- 3Positive FCF means a company can fund dividends, buybacks, and growth without external financing
- 4FCF yield (FCF / enterprise value) is one of the best valuation metrics
- 5Our profitability factor incorporates cash-based measures that capture FCF quality
#What Is Free Cash Flow?
Free cash flow (FCF) is the cash a company generates from its core business operations after subtracting the money spent on maintaining and expanding its asset base.
Formula: Free Cash Flow = Operating Cash Flow - Capital Expenditures
Think of it this way: operating cash flow is the cash the business generates from selling products and services. Capital expenditures are what it spends to maintain factories, equipment, and infrastructure. What remains is "free" — available for shareholders.
#Why FCF Matters More Than Earnings
Accounting earnings (net income) can be manipulated through accruals, depreciation methods, and one-time items. Free cash flow is much harder to fake because it measures actual cash movements.
| Metric | Can Be Manipulated? | What It Measures |
|---|---|---|
| Net Income | Yes — through accruals | Accounting profit |
| EBITDA | Somewhat | Pre-depreciation earnings |
| Operating Cash Flow | Difficult | Cash from operations |
| Free Cash Flow | Most difficult | Cash available to shareholders |
#How Companies Use Free Cash Flow
Positive free cash flow gives management four options:
- 1Pay dividends — Return cash directly to shareholders
- 2Buy back shares — Reduce share count, increasing per-share value
- 3Pay down debt — Strengthen the balance sheet
- 4Reinvest in growth — Fund acquisitions or organic expansion
The best capital allocators balance these options based on relative returns.
#FCF Yield: The Valuation Metric
FCF Yield = Free Cash Flow / Enterprise Value
| FCF Yield | Interpretation |
|---|---|
| Below 2% | Expensive — limited cash return |
| 2-4% | Fair value for growth companies |
| 4-6% | Attractive for quality companies |
| 6-8% | Cheap — if quality supports it |
| Above 8% | Very cheap or potential red flag |
Higher FCF yield means you are paying less for each dollar of cash the company generates.
#FCF Quality Indicators
Not all FCF is created equal:
- Consistency — Steady FCF over multiple years is more reliable than one good year
- Growth — FCF growing faster than revenue suggests improving efficiency
- Conversion — FCF as a percentage of net income above 80% indicates high earnings quality
- Sustainability — FCF that requires minimal capex is more durable than FCF from deferred maintenance
#How Our Model Captures FCF Quality
Our profitability factor uses cash-based operating profitability (following Ball et al., 2016), which closely aligns with free cash flow quality. Companies that generate strong FCF relative to assets score highly on our profitability measure.
Last updated: February 10, 2026