Free Cash Flow (FCF)

I put a lot of focus on FCF when analyzing IPO deals based on S-1 forms. Readers without finance training might wonder why. They would also wonder why there are endless versions of equation to arrive at FCF.

Here I'll explain "why it is not straightforward" rather than "how it should be calculated".

The complexity of dealing with FCF -- as opposed to building Income Statement and arriving at net income -- lies fundamentally on the intention of using a certain FCF figures.

In the simplest sense, one could derive FCF by taking the Cash Flow statement and adding Operating Cash Flow (OCF) and Investment Cash Flow (ICF):

  • FCF = OCF + ICF

You might find some texts describing this equation in a different way, such as FCF is OCF minus all Capital Expenditures (Capex). It's just a difference in signs. The meaning and the value are the same for both definition.

This seems simple, OCF + ICF, so what's the fuss with all the other 101 equations?

Well, there are several problems with this equation in practice:

First, this FCF equation requires that one has the Cash Flow statement. As anyone that had struggled to "close the loop" of the three accounting statements in accounting classes would know, CF is usually the last one to be available. This means deriving FCF from CF statement is after-the-fact. It's not useful in anything forward looking - which is actually the whole purpose of finance, as opposed to accounting.

Second, this FCF is highly obscured by tax payments, which is compounded by tax-deductible interest payments due to bank loans or corporate bonds on the balance sheets. Just think about it as a really messed-up number whose fluctuation depends on tax and interest, which are not necessarily linked to the core operation of the business activities. Therefore it's also less useful for forward-looking financial planning, as well as the valuation.

Because of these reasons, this simplest form of FCF is practically useless and rarely used, despite being correct definition-wise.

From this simple equation, one could go infinitely complicated in arriving at an FCF by grabbing numbers at the same time from Income Statements and Balance Sheets. The most complicated one for the purpose of financial operation to my knowledge is that of a LBO model.

This is because the whole point of LBO is to use financial structuring to fund the acquisition of a particular future cash flow stream. This means that the FCF has to be determined as purely based on the operating activities, not obscured by tax, interest, depreciation, one-time-charge/gain, excess cash, etc.

I will spare you for the several commonly used FCF equations for LBO purpose, as we're not in LBO business here.

So how about FCF for a startup going IPO?

Actually, most of the S-1 forms filed by tech startups would use the simple equation mentioned above. For example, in Dropbox's S-1 form it is stated:

"We define free cash flow, or FCF, as net cash provided by operating activities less capital expenditures."

One reason why this makes reasonable sense for "analyzing the past performances" of a tech startup is because:

  • Tech startups are usually still losing money at IPO, which means they don't really pay taxes, removing (largely) the obscuring part of tax-payment from the cash flows.
  • Most tech startups don't have significant amount of high-interest-rate term loans. This also means the interest part is negligible most of the time (but not all the time).

Note that even without tax and interest, this number is still not very useful for anyone trying to establish the valuation for, let's say, Dropbox's IPO, because Capex is key to a startup's growth. Even if one knows the Capex of the previous accounting year, the future Capex level will depend largely on the founders' plan to pursue growth.

The OCF is then largely dependent on these Capex, which some layered delays over the years. The true FCF projection for the next 10 years could then be a much more complicated job than looking at the OCF + ICF in the previous 3 years and project forward.

Bottom line is: a quick check on FCF of a startup upon IPO does give one more sense about whether the company needs a lot more new capital post-IPO or it's more or less self-sustainable. But don't expect there to be a magic bullet that would help you build "meaningful FCF projections" and arrive at an "intrinsic" valuation.

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