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Tuesday, October 16, 2012

Importance of Free Cash Flows for Long Term Investors

Long-term investors in the stock market are betting that the future of companies today will be better than the present or at least as good. The basic idea is that profits drive stock prices and companies that can deliver consistent profits today and are in position to continue delivering profits are prime targets for long-term investors.

There are many keys to determining whether a company is a good long-term investment or not, but one of the most important is free cash flow.

Without sustained and strong free cash flow, it is difficult to see our company has a competitive advantage or is positioned to deliver profits over the long term. A competitive advantage, also called an economic moat, gives the company an edge going forward and makes it more difficult for competitors to eat into market share.

Many long-term investors insist that a company have a strong record of free cash flow before they will even consider further investigation.

Free cash flow is the cash left over after the company pays all its bills and invests in future growth. Companies may invest this cash in short-term investments or use it for research and development, acquisitions or other extraordinary expenses that are not normally included in day-to-day operating cost.

Free cash flow may seem like esoteric accounting jargon, but is really quite simple when you think about it. If you pay all your bills every month and fund your retirement account and any other investment programs you have and still have money left over you have free cash flow.

That extra cash is not committed to anything such as car payments or student loans or insurance. Because those all been taken care of already.

Most define free cash flow as operating cash flow minus capital expenses investments. Operating cash flow is the money generated from the business of the company, as opposed to funds derived from the sale of a subsidiary for example.

These numbers can be found on the company's statement of cash flows, although many financial websites report these numbers.

What should investors look for in terms of free cash flow and how should they measure its impact on the company?

One of most common ways to measure the strength of free cash flow is to look at it as a percentage of sales. If that percentage exceeds 5 to 7% of sales, then it is a good assumption that this company probably has a competitive advantage or economic moat.

Financially strong companies often have high operating margins and lower expenses than their competitors.

Free cash flow, like all other financial measures makes more sense when viewed in context. Compare it to other companies in its industry and look back to determine if the strong free cash flow has a history or is something new to the company.

Although there are many other factors to consider, a history of strong free cash flow is a good indication that the company probably has a competitive advantage and is worthy of a deeper dive into the other factors that determine whether it is in fact a good long-term investment bet.

Many long-term investors reject companies as investment candidate that do not have a history of strong free cash flow.