Free Cash Flow (FCF) is the cash flow generated by the core operations of the company after deducting the investments in new capital. Mathematically,
FCF = NOPLAT – Net Investment
NOPLAT = Net Operating Profit Less Adjusted Tax, represents the profits generated by the core operations, minus the taxes. It excludes non-operating income and interest expense.
Net Investment = Increase in the invested capital from Year 1 to Year 2. Net Investment in non-operating assets, and gains/losses/income related to these non-operating assets are not considered.
FCF = NOPLAT + Non-cash Operating Expenses – Investments in Invested Capital
Non-cash Operating Expenses are those expenses that are deducted from the revenue to generate NOPLAT. Depreciation and non-cash employee compensation are two most common ones. We do not add back the amortization and impairment of intangibles to NOPLAT.
Investments in Invested Capital: To grow the business, companies consistently invest a portion of the gross cash flow back into the business. Four categories form gross investment:
- Operating Working Capital: Investments primarily in operating cash and inventory. Non-operating assets (excess cash) and financing (dividends payable, short-term debt) are excluded from Operation working capital.
- Net Capital Expenditures equals investment in Property, Plant and Equipment (PP&E), minus the book value of any sold PP&E. It is determined by adding the increase in net PP&E to depreciation. Do not estimate the capital expenditures by the change in the gross PP&E since it can understate the actual amount.
- Include investment in capitalized in the gross investment.,
- Goodwill and acquired intangibles: For acquired ones, where cumulative amortization has been added back, we can calculate the investment by the change in the net goodwill and intangibles. For intangibles that are been amortized, add the increase in net intangible to amortization.