What is Free Cash Flow, and How Can You Use It Effectively to Gauge Investments?

By Markets Fool.com

It's back to school week for Industry Focus! In this week's Energy and Industrials episode, Sean O'Reilly and Taylor Muckerman are taking a look at free cash flow. Listen in to find out what it means, how to calculate it, why investors should absolutely look at this number in addition to net income, and how to look at the number before you buy into a company.

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Also, the hosts take a look at what's been a very busy week for oil news -- Apache's (NYSE: APA) find of 2 billion barrels in the Permian, Spectra Energy's (NYSE: SE) acquisition by Enbridge (NYSE: ENB), and EOG's (NYSE: EOG) newest acquisition.

A full transcript follows the video.

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This podcast was recorded on Sep. 8, 2016.

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Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, September 8th, 2016, so we're talking about energy, materials and industrials. I'm joined in studio by The Motley Fool's very own Taylor Muckerman. Taylor, are you ready for back to school week?

Taylor Muckerman: Not as much as I'm ready for football tonight.

O'Reilly: Really?

Muckerman: Sure.

O'Reilly: What do you think the spread is going to be?

Muckerman: I think it's minus 3 Carolina. I'm taking them.

O'Reilly: You think it's going to happen?

Muckerman: Yeah.

O'Reilly: So, it happens to be back-to-school week on Industry Focus.

Muckerman: What's that?

O'Reilly: All the kiddies are going back to school, and we needed a theme week, and we had no other ideas -- that's a little bit of insider info for our listeners, there. So, what we're doing is taking an investing term or concept and taking our listeners "to school" on how they can use it in their own investing. If the term can be discussed in the context of each show's specific industry, so much the better. So, before we jump into that, we were all set to do this, but we had to talk about a couple of energy news items.

Muckerman: Fine, fine.

O'Reilly: I actually don't even have notes about this, what's up with this couple billion barrel find out in the Delaware Basin?

Muckerman: Yeah, Apache striking liquid gold. Two billion barrels found --

O'Reilly: I thought it was three. It's a lot.

Muckerman: At least two billion barrels of oil. They're saying it's a new West Texas field, it's in a far-off corner of the Permian Basin. Two billion, that's the biggest find in several years.

O'Reilly: So, what did you mean when you said that just now? It'd been drilled a hundred years ago and everyone forgot about it?

Muckerman: I guess, geologists figured that it really wasn't conducive to fracking, but now Apache is looking at what could be an $8 billion oil field. Hence, they were up double-digit percent yesterday.

O'Reilly: Yeah. That's pretty good. Speaking of double-digit percentage gains, Spectra Energy getting bought out for $33 billion.

Muckerman: Something like that.

O'Reilly: This shocked everybody, right?

Muckerman: Yeah, I think it did. Neither company is struggling. I think Enbridge just wants to diversify. It's traditionally more oil heavy, and Spectra is very much more natural gas heavy. So, they decided to pony up and create the largest energy infrastructure company in North America by a very wide margin. Take that, Kinder Morgan!

O'Reilly: Poor Kinder Morgan.

Muckerman: Womp womp. First, they cut their dividend, now they're second-best. Well, second biggest. Best is a different argument.

O'Reilly: They're going to have to buy Oneok or something. (laughs)

Muckerman: Who knows. They need to worry about that debt that they cut their dividend to pay off.

O'Reilly: So, this was just a stock deal, right?

Muckerman: All-stock deal. I think Enbridge shareholders will own around 57% of the company, Spectra shareholders will own 43% of the company, give or take a tenth or a hundredth, somewhere along the line.

O'Reilly: Everybody's buying stuff this week.

Muckerman: Big week.

O'Reilly: EOG announced over the weekend, was it? Monday?

Muckerman: It came out on the Sept. 6.

O'Reilly: They bought a small private oil and gas producer. By small, I mean $2.3 billion. Is this the sign that things are turning?

Muckerman: It could be. EOG is traditionally not an acquisitive company, because they like what they own and they figure they could get a higher return on just drilling what they know they have, which has shown to be superior to most other companies' land holdings. But this company had some acreage. I say some, it's a considerable amount, obviously, if you're paying over $2 billion for it, that bordered on some of their acreage. So, now they can drill longer horizontal wells to access that oil without having to drill multiple wells. It's kind of just supplementing the acreage they already own, expanding their footprint rather than buying up somewhere else in the country. It's basically just, their blob is growing.

O'Reilly: Right. So, this still fits within their corporate culture.

Muckerman: Absolutely.

O'Reilly: So, Professor Muckerman, we're the lucky individuals who get to talk for back-to-school week about free cash flow. This is a term that you google, and it has more than one definition. I would also argue that it depends on who you're talking to. But, to start us off, could you give us a layman's definition of what you think free cash flow is?

Muckerman: It's cash that's given to you.

O'Reilly: Like if I give you $10 right now?

Muckerman: Yeah, that's free cash flow. No, basically, the more important definition of net income is the cash that you've actually earned rather than the financially finagled net-income figure. So, you're adding back changes in inventory, changes in accounts receivable, things like that which are considered working capital. You're also taking care of depreciation and amortization, and then subtracting capital expenditures. So, you're basically taking your cash from operations, subtracting capital expenditures. There you are, free cash flow.

O'Reilly: You threw out a lot of accounting terms there, and the kid in the back of the classroom just fell asleep. I saw him nod out there a little bit.

Muckerman: I know that kid, I've seen that kid before.

O'Reilly: To the front of the class, Jimmy! Really quick, why is GAAP, net income, EPS, that stuff, why is that not the only thing or the best thing for investors to look at? You said it's kind of made up -- what do you mean by that? If I buy Google, am I not actually earning that money that's their net income line? What do you mean?

Muckerman: You're taking non-cash charges. If your inventory is higher than it was the previous year, that's not more money you have, that's just a balance sheet item that's increased. If you have less accounts receivable, you might have less money coming to you, but you don't have that money, so that change doesn't need to be accounted for in net income. Depreciation is a non-cash charge, that's a write-down of your assets.

O'Reilly: That's a figment of an accountant's imagination.

Muckerman: Yeah. So, you're accounting for the finagling of assets that get mixed into net income, and you're stripping those out. Obviously, you're not going to get paid by non-cash items, so why consider that in your cash flow?

O'Reilly: Yeah. In addition to that, I was going to say this later, it's going to be, like, 98% of what you're looking for, but I normally just subtract capex from cash from operations.

Muckerman: Yeah, that's basically the formula that we talked about. Net income accounting for depreciation and amortization, changes and net working capital, EBIT, you have to take into account taxes that you're paying, and then interest. That basically boils down to cash flow from operations. So, you're just taking all that and turning it into one phrase. And then, you subtract capital expenditures from that, and you're left with money to pay off debt and...

O'Reilly: Party.

Muckerman: ... pay off dividends, or party, yeah. Get a corporate jet.

O'Reilly: I remember, talking about free cash flow, it was called something different.

Muckerman: The mother's milk? Did someone say that?

O'Reilly: Yeah, it is. No, you know all those stupid Buffett books that came out in the late 1990s?

Muckerman: Stupid Buffett books?! Heresy!

O'Reilly: There were like 500 of them. There was like "The Warren Buffett Way," and all those.

Muckerman: Oh, not written by him, written about him.

O'Reilly: Yeah. No, I'd kill for him to write a book. Actually, do you know he said that if he would ever write a book, he would make it a fiction book? Somebody asked him about that.

Muckerman: Why not? He's a jokester. Everybody else would be clamoring for an actual book they could learn something from.

O'Reilly: Yeah. But, what he would do is, it would be fiction, and it would be during the financial crisis: What if Bank of America hadn't bought Merrill Lynch, and what would have happened? And he's like, "I don't know, but it probably would be bad."

Muckerman: We know you're listening, Warren. Write it.

O'Reilly: Yes, you're one of our loyal listeners. So, free cash flow -- obviously, kind of a fictional number, especially if you're multiplying by a tax rate on something that you calculate and all that stuff. You're an analyst for Motley Fool Canada, a stock-picking service that's about to have its three-year anniversary, congratulations.

Muckerman: Thank you, yeah, next month October.

O'Reilly: You guys are also beating the market.

Muckerman: Yeah, we're up slightly, we're up 9.3% as of right now. The TSX is up around 9% over that time. So slightly beating, but beating nonetheless.

O'Reilly: The commodity toughness is probably not helping.

Muckerman: We actually escaped a lot of that because we don't recommend any oil producers, we only recommend pipeline companies and services companies.

O'Reilly: Going midstream. But, as an analyst on the stock picking service, how do you and your team use free cash flow when you're picking stocks? Do you focus on free cash flow? Do you care?

Muckerman: Yeah, it's definitely something we focus on, one of the more highly valued things that we focus on. That's money that you're taking forward to the next year that you can then use to expand the business or return to shareholders. So, basically, that's exactly what we want out of a company: growing or returning. You would assume that growth would turn into returns further down the line. So, that's one of the main things that I'm looking for, free cash flow growth year-over-year, or free cash flow compared to your revenues, how much of your sales are you turning into free cash flow. So, those are definitely some metrics that we focus on.

O'Reilly: If I were to ask you to name a company that is awesome at generating free cash flow, what's the first one that comes to mind?

Muckerman: There's a lot of services companies out there. Right now, what you're seeing is producers that are struggling because they have high capital expenditure budgets, and now their revenue is declining and their net income is declining. So, some service companies -- one that we recommend in Stock Advisor Canada is Enerflex ...

O'Reilly: You made that up.

Muckerman: No, it's traded on the Toronto Stock Exchange. Ticker EFX.

O'Reilly: I hope they do exist.

Muckerman: It's a pipeline services company. They're not a pipeline operator, but they do service pipelines. So, that's one company that's out there making money. Their capital expenditures aren't necessarily quite as high as even a pipeline company, because they're not expanding their geographic footprint. As pipelines grow, their business grows, and aging pipelines are a big business for them as well. And then, you have all three major U.S. services companies -- Schlumberger, Halliburton,and Baker Hughes -- all ranking very highly on free cash flow generation. I'm talking right now about seven-year CAGR -- compound annual growth rate -- of free cash flow growth, and all three of those companies rank in the top deciles of the energy market.

O'Reilly: OK, so, I pulled up Halliburton. For our listeners who want to follow along, go to sec.gov and type in ... just kidding.

Muckerman: Well, this is a class, right? So follow along, darn it!

O'Reilly: Follow along, Jimmy, and get to the front of the class here. In 2015, this is on their cash flow statement, it's one of the three major statements that every company is required to --

Muckerman: Hold on, I'm clicking over. It's arguably the most important. Basically, the other two statements are dumped in it.

O'Reilly: You can see where everything is flowing.

Muckerman: You can see dividends being paid, you can see interest being paid, you can see debt being taken on or debt being repaid, and then all the income and everything right there.

O'Reilly: So, for the class, in fiscal year 2015 -- is that OK with you, to use 2015?

Muckerman: It's the last fiscal year.

O'Reilly: Net income for Halliburton of negative $671 million.

Muckerman: What!?

O'Reilly: Oh my gosh, they lost money?!

Muckerman: I hate that business!

O'Reilly: This is terrible!

Muckerman: This is the worst business on the planet!

O'Reilly: However, you add back depreciation and amortization -- that is a non-cash charge. Their assets are aging, but this is not money out the door.

Muckerman: No it is not.

O'Reilly: So, automatically, they're earning money again. We're adding back $1.8 billion. Got a loss there of $1.1 billion from non-operating activities, I'm not sure what that is.

Muckerman: That's going to be those one-time charges like layoffs or restructuring or asset write-downs.

O'Reilly: They probably laid off a few people last year, you're right.

Muckerman: They did, unfortunately.

O'Reilly: Changes in accounts receivable. That went up by $1.468 billion. Change in accounts payable, -$603 million. So, cash from operations: $2.9 billion. We're doing alright.

Muckerman: Dun dun dun-dun!

O'Reilly: And last year, they invested just $2.18 billion, so free cash flow of a little over $700 million to party with.

Muckerman: Basically flipped the script on that $671 million loss.

O'Reilly: Not too shabby.

Muckerman: Not too shabby at all.

O'Reilly: Let's rewind. Can you think of any companies that are terrible free cash flow generators, that maybe even show GAAP profits all the time?

Muckerman: Well, just to top the list, I ran the same screen -- seven-year compound annual growth rate of free cash flow growth.

O'Reilly: Who's the worst of the worst?

Muckerman: You'll never guess who's at the top of this list.

O'Reilly: For the worst?

Muckerman: For the worst. This is a negative compound annual growth rate over the last seven years for their free cash flow.

O'Reilly: And it's in our sector? Energy, materials and industrials?

Muckerman: Yeah. It's at the top of another list, too. It's a pop quiz.

O'Reilly: Is it Chesapeake Energy?

Muckerman: No.

O'Reilly: Aw, shoot.

Muckerman: It's Exxon (NYSE: XOM).

O'Reilly: Really?!

Muckerman: Yeah. Because they have such huge capital expenditures. Massive capital expenditures. So, when you have this flip-flop in oil prices ... and, to let everybody know, seven years ago, September 2009, oil prices were in the mid-$60s. So, it's not a terribly different environment, as you remember, oil had gotten above $150 before the financial crisis, and plummeted along with the rest of the economy.

O'Reilly: Yeah, here it is. 2014, for our listeners, Exxon generated free cash flow of ... $45 billion from operations, $33 billion spent, so, $12 billion. But, this last year, 2015, they generated just $3 billion in free cash flow. And the last 12 months, which includes the latest couple quarters, it's basically breaking even on a cash basis.

Muckerman: It's not negative free cash flow, but negative free cash flow growth.

O'Reilly: Oof! Exxon ... and to make matters worse, they're still paying that dividend!

Muckerman: And to make matters even worse, they're not replacing 100% of their oil at the moment.

O'Reilly: Dun dun dun.

Muckerman: But they're still the biggest publicly traded oil company in the world.

O'Reilly: Yeah, so they're fine. So, before we say class is dismissed and send everybody home to do their homework, do you have any final thoughts or takeaways that you might want to give everybody to think about when they're walking home?

Muckerman: Yeah. Just to show you right there, the largest oil company publicly traded here in the United States is the worst at free cash flow growth over the last seven years. But, has it been a terrible investment in the last seven years? No. The cyclicality of the oil industry can affect some figures like free cash flow, but they are still making free cash, so they're still able to return that to shareholders, or reinvest it back into the business, as we've seen with capital expenditures being, what did you say, $35 billion?

O'Reilly: Yeah, every year.

Muckerman: So, they're growing the business, or at least maintaining the business. It's not the end-all be-all factor to look at.

O'Reilly: It's a number, and you need to know the story and the reasons for the number.

Muckerman: Exactly. It's a worthwhile screen. But if your company isn't producing free cash flow, you might want to worry a little bit, unless it's a hyper-growth company in a very early stage. If it's a late-stage company and free cash flow suddenly disappears ...

O'Reilly: That's bad.

Muckerman: Then ask, why?

O'Reilly: Awesome. Thank you for your thoughts.

Muckerman: You got it.

O'Reilly: Have a good one.

Muckerman: You too.

O'Reilly: That is it for us folks. We'd like to give a special shout-out for our producer, Austin Morgan, who is behind the glass as we speak working his video and audio magic. And if you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at industryfocus@fool.com. Once again, that's industryfocus@fool.com.

As always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman, I am Sean O'Reilly. Thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Sean O'Reilly has no position in any stocks mentioned. Taylor Muckerman owns shares of Alphabet (C shares), Halliburton, and Spectra Energy. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Kinder Morgan, ONEOK, and Spectra Energy. The Motley Fool owns shares of EOG Resources, ExxonMobil, and Halliburton. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.