Most of my points have already been made (CapEx is lumpy, and companies go through intense investment periods; it's important to separate maintenance CapEx from growth CapEx as a company can under-invest and generate good FCF and ROIC initially, but it's not sustainable)
I look at earnings quality and cash conversion ratio when analysing a company - over 5 to 10 years, how well does EBITDA reflect Cash Flow From Operations, how well does CFFO reflect earnings (should be better than 100% due to D&A exclusion), and how well do earnings convert into free cash flow?
Aligned with Matt's comments, I'm suspicious of a company with very high or very low earnings quality or conversion ratio much over 100% for an extended period (unless that is obviously linked to the business model)
Perfect points, my friend! Indeed, converting above 100% is unusual (and likely unsustainable). it's also important to separate maintenance CAPEX from growth CAPEX.
I recently analyzed CrowdStrike, which reported a negative net income and appeared unprofitable. However, it had significant R&D investments that weren't accounted for, and with depreciation, this metric did not accurately reflect the company's financial performance. Upon further analysis of FCF, it became clear that this was not the case. Further taking into account cash and cash equivalents, I realized that they had a more nuanced approach to managing their profits, assets, and other key metrics.
Additionally, understanding FCF can help an investor look out for possible changes in a company. For example, if a private equity firm becomes involved, noticing that the company has healthy cash flow and free cash flow, it may conduct a reorg to try to bolster the company and drive growth. Of course, this is very specific, but it illustrates how much more an investor can understand and make predictions about a company beyond metrics like net income and other ones that don't showcase the workings and interconnectedness of a company.
Now to the inevitable question: what business will generate the highest FCF in relation to its investment, for the next 10yrs? I would bet it’s one of the Critical Minerals to the energy transition. What about you?
Loved this breakdown, Jimmy. Clear, practical, and no fluff. “Earnings might win the quarter, but free cash flow wins the decade” that line says it all. Looking forward to more deep dives like this!
FCF filters out the noise. It’s the purest signal of a business’s true health and durability — especially when paired with ROIC. Great reminder that real value shows up in cash, not accounting tricks.
As a quant investor I agree. Regardless of the fact that FCF can be lumpy and that high FCF is no guarantee of future high FCF, both current and forward FCF yield are more important factors than earnings yield, at least when considering price performance of the stock for the next 6 to 12 months.
Investors need to stop getting a hard on over FCF. Yes, FCF is what ultimately matters for a business, but cash flow in any given year is often completely unrepresentative of profitability, because capex is lumpy and working capital flows in and out. Most growing businesses generate zero cash flow for years, even decades, because they're reinvesting all that cash into working capital and fixed assets, to expand the business. But the underlying business may still be incredibly profitable, and the second they stop growing so fast, that will come through.
That is exactly the reason accrual accounting was invented. "Not all changes of wealth are cash-based, and not all flows of cash change wealth." If I was asked to estimate a company's value knowing either its single-year net income or its single-year cash flow, I would much rather have the net income figure, despite all its issues.
Also, the quote, "A company is nothing more than people, processes, and a bank account" - the reason people don't say that it because it isn't true. You forgot non-cash capital. That stuff matters.
What I said was “net income doesn’t matter,” not “profitability doesn’t matter.” Profitability obviously matters. But OK, you can try valuing a business based solely on net income while it’s investing millions into projects that generate returns below the cost of capital (i.e., projects that destroy value).
"FCF tells you what’s available; ROIC tells you how efficiently it’s being used."
You even said it yourself: “FCF is what ultimately matters for a business.” So I’m not sure why the pushback - we’re basically making the same point as the article.
I think I presented my argument fairly clearly, but just to add a bit more colour: FCF over the life of the business is what ultimately matters, but FCF now is often not a good indicator of FCF in the future. Very profitable businesses can have zero or negative FCF for a long time, all the while growing and compounding intrinsic value.
There are essentially two big differences between net income and free cash flow. The first is change in working capital. I hope you would agree that investment in working capital does not reflect a cost to the business, nor does a release of working capital reflect a profit. Most investors adjust NWC changes out of FCF when looking at P/FCF or similar. If you’re doing a DCF, you should account for an increase in NWC over time as the business grows, and a decrease as it shrinks (assuming it is not a NNWC business). This impacts the intrinsic value of the company. But if you’re not doing a proper DCF, you want to understand how *profitable* the business is, and you should take out changes in NWC for that.
The second difference is that FCF uses capex where net income uses depreciation. There are a couple issues with using raw capex - first, as mentioned, it’s lumpy. You need to take a multi-year average to even that out (depreciation does this for you, so doesn’t face the same issue). The second is that, for growing businesses, much of that capex is related to expansion, not the existing business, so again subtracting it doesn’t really reflect economic reality and results in a number that understates profitability.
Depreciation accounts of the cost of the PPE when it is used, rather than when it is bought. The result is that it better reflects steady-state profitability.
There are problems with depreciation too, of course. Spending money now is worse than spending it over the next 5 years due to the time value of money, so depreciation can give a flawed view of the economics / IRR. Also, yes, the money can be spaffed away on capex that doesn’t turn a profit so destroys shareholder value, and the income statement won’t immediately reflect that loss. However, it will recognise it over the lifetime of the project it was spent on - whether that reflects economic reality better than recognising the loss immediately is basically a philosophical question. But what is not in doubt is that subtracting all capex, treating it effectively like a loss regardless of whether it’s being wasted, is a worse solution.
The best way to deal with things on the capex front is to estimate average maintenance capex, and subtract this. That’s what Buffett uses in his owner earnings calculation.
Sorry for the long ass comment. But the headline point is - yes, FCF over the lifetime is what ultimately determines the value of the business - but current FCF is often not a good indicator of profitability, and hence P/FCF is for many businesses not a useful valuation metric.
The cash flow statement captures a snapshot in time.
Imagine I buy cans of Coca Cola for 50c and sell them for $1. Now imagine I pay my supplier in arrears but collect from customers today - a nice working capital situation.
My cash flow statement today shows only money coming in - there is no cash outflow yet. So today, my cash flows look great.
When I pay my supplier, the cash flows don't look quite so good anymore - even though nothing really changed.
Now consider stock based comp. It is added back to net income as a "non-cash" expense!! If it isn't a cost what is it?
Companies are playing games with the same deferral mechanism I described with reference to the Coca Cola cans.
To make matters worse, the true cost will invariably be multiples higher at the time of vesting, so the recorded cost is wholly unreliable.
So Operating Cash Flows are often unreliable numbers - yet they are a primary input into FCF.
So FCF is very often unreliable.
Back to your statement "FCF is hard to fake" - perhaps you would you like to reconsider?
You raise thoughtful points - but I still stand by the statement: “FCF is hard to fake.” Not impossible, but hard. Let me explain...
You're absolutely right that working capital timing, especially favorable payment terms (paying suppliers later, collecting from customers early), can distort cash flows in a specific period. But over time, these effects normalize. Deferred payables eventually get paid, and receivables eventually need to be collected. So while FCF can be flattered temporarily, it's much harder to sustain this illusion over multiple periods.
your Coca-Cola analogy highlights this: the timing impact shows up in one reporting period, but not across several. Markets and analysts watching trends over quarters (or years) will easily spot this reversal. It’s a temporary boost - not true free cash flow generation.
On stock-based comp, I agree with you: it’s a real economic cost, despite being labeled “non-cash.” But this is precisely why thoughtful FCF analysis adjusts for it. Sophisticated investors don't take reported FCF at face value - they normalize for dilution, capital intensity, and even aggressive adjustments like SBC.
And importantly, SBC doesn't show up in the cash flow statement at all, so it doesn’t directly inflate FCF unless you blindly use the “Operating Cash Flow - CAPEX” formula without nuance.
so yes, companies can game certain components, but it’s significantly harder to manipulate cash than it is to manipulate accrual-based earnings. FCF may not be perfect, but it’s still a more robust measure of economic reality than net income.
To fake FCF consistently, a company would need to:
1. Stretch payables every quarter (unsustainable)
2. Sell receivables (easy to spot)
3. Underinvest in capex (which shows up eventually in growth shortfalls)
4. Rely heavily on adjustments like SBC (which again, can be accounted for)
In other words, it’s hard to fake (especially over time)
Thanks for contributing to the discussion, James!!! You brought up some excellent points.
When asked about his strategy for turning the company around, Jobs shared the following advice:
“Somebody taught me a long time ago a very valuable lesson which is if you do the right things on the top line, the bottom line will follow. And what they meant by that was: if you get the right strategy, if you have the right people, and if you have the right culture at your company, you’ll do the right products. You’ll do the right marketing. You’ll do the right things logistically and in manufacturing and distribution. And if you do all those things right, the bottom line will follow.”
— Steve Jobs
Top Line : Net Income, ROIC, ROA
Bottom Line : Free Cash Flow, CROIC
CROIC = ROIC × Earning Quality (FCF/Net Income)
ROIC = Net Income ÷ Invested Capital
FCF Activator :
Earning to FCF Mechanism Conversion Efficiency (FCF/Net Income)
As I said, the definitions I gave are the standard meaning in common parlance. Top line and bottom line refer to the lines of the income statement, where revenue is at the top and income at the bottom.
I’m 100% with you on this, JR! Both are absolutely essential.
FCF tells you what’s available; ROIC tells you how efficiently it’s being used.
The key point is: investing millions in working capital and CAPEX just to boost EPS or something similar isn’t enough. Net income on its own doesn’t cut it - it needs to be creating value over time. Otherwise, it truly doesn’t matter.
Most of my points have already been made (CapEx is lumpy, and companies go through intense investment periods; it's important to separate maintenance CapEx from growth CapEx as a company can under-invest and generate good FCF and ROIC initially, but it's not sustainable)
I look at earnings quality and cash conversion ratio when analysing a company - over 5 to 10 years, how well does EBITDA reflect Cash Flow From Operations, how well does CFFO reflect earnings (should be better than 100% due to D&A exclusion), and how well do earnings convert into free cash flow?
Aligned with Matt's comments, I'm suspicious of a company with very high or very low earnings quality or conversion ratio much over 100% for an extended period (unless that is obviously linked to the business model)
Perfect points, my friend! Indeed, converting above 100% is unusual (and likely unsustainable). it's also important to separate maintenance CAPEX from growth CAPEX.
This is an excellent informative analysis.
I recently analyzed CrowdStrike, which reported a negative net income and appeared unprofitable. However, it had significant R&D investments that weren't accounted for, and with depreciation, this metric did not accurately reflect the company's financial performance. Upon further analysis of FCF, it became clear that this was not the case. Further taking into account cash and cash equivalents, I realized that they had a more nuanced approach to managing their profits, assets, and other key metrics.
Additionally, understanding FCF can help an investor look out for possible changes in a company. For example, if a private equity firm becomes involved, noticing that the company has healthy cash flow and free cash flow, it may conduct a reorg to try to bolster the company and drive growth. Of course, this is very specific, but it illustrates how much more an investor can understand and make predictions about a company beyond metrics like net income and other ones that don't showcase the workings and interconnectedness of a company.
Thanks for sharing!
Thank you so much, Tayga!
Over an adequate extended period of time, the average CROIC will merge with the average ROIC, spiralling each other over the time horizon.
Nice one Jimmy!
Completely agree, “Cash is King”.
Now to the inevitable question: what business will generate the highest FCF in relation to its investment, for the next 10yrs? I would bet it’s one of the Critical Minerals to the energy transition. What about you?
I don't know. Maybe META...
Loved this breakdown, Jimmy. Clear, practical, and no fluff. “Earnings might win the quarter, but free cash flow wins the decade” that line says it all. Looking forward to more deep dives like this!
Thank you very much for the feedback, Pavan! I’m glad you liked it. We’ll do our best to meet your expectations.
Great post! We made a post about free cash flow as well.
🎓 From Revenue to Free Cash Flow: A Complete Guide:
https://www.ftrinvestors.com/p/from-revenue-to-free-cash-flow-a
Great post, my friends!!!
FCF filters out the noise. It’s the purest signal of a business’s true health and durability — especially when paired with ROIC. Great reminder that real value shows up in cash, not accounting tricks.
Absolutely. What really matters is money in the bank.
As a quant investor I agree. Regardless of the fact that FCF can be lumpy and that high FCF is no guarantee of future high FCF, both current and forward FCF yield are more important factors than earnings yield, at least when considering price performance of the stock for the next 6 to 12 months.
Couldn’t agree more, Peter!
Hot take warning.
Investors need to stop getting a hard on over FCF. Yes, FCF is what ultimately matters for a business, but cash flow in any given year is often completely unrepresentative of profitability, because capex is lumpy and working capital flows in and out. Most growing businesses generate zero cash flow for years, even decades, because they're reinvesting all that cash into working capital and fixed assets, to expand the business. But the underlying business may still be incredibly profitable, and the second they stop growing so fast, that will come through.
That is exactly the reason accrual accounting was invented. "Not all changes of wealth are cash-based, and not all flows of cash change wealth." If I was asked to estimate a company's value knowing either its single-year net income or its single-year cash flow, I would much rather have the net income figure, despite all its issues.
Also, the quote, "A company is nothing more than people, processes, and a bank account" - the reason people don't say that it because it isn't true. You forgot non-cash capital. That stuff matters.
Hi Matt,
Thanks for the comment!
I think there might’ve been a misunderstanding…
What I said was “net income doesn’t matter,” not “profitability doesn’t matter.” Profitability obviously matters. But OK, you can try valuing a business based solely on net income while it’s investing millions into projects that generate returns below the cost of capital (i.e., projects that destroy value).
"FCF tells you what’s available; ROIC tells you how efficiently it’s being used."
You even said it yourself: “FCF is what ultimately matters for a business.” So I’m not sure why the pushback - we’re basically making the same point as the article.
Hi Jimmy.
I think I presented my argument fairly clearly, but just to add a bit more colour: FCF over the life of the business is what ultimately matters, but FCF now is often not a good indicator of FCF in the future. Very profitable businesses can have zero or negative FCF for a long time, all the while growing and compounding intrinsic value.
There are essentially two big differences between net income and free cash flow. The first is change in working capital. I hope you would agree that investment in working capital does not reflect a cost to the business, nor does a release of working capital reflect a profit. Most investors adjust NWC changes out of FCF when looking at P/FCF or similar. If you’re doing a DCF, you should account for an increase in NWC over time as the business grows, and a decrease as it shrinks (assuming it is not a NNWC business). This impacts the intrinsic value of the company. But if you’re not doing a proper DCF, you want to understand how *profitable* the business is, and you should take out changes in NWC for that.
The second difference is that FCF uses capex where net income uses depreciation. There are a couple issues with using raw capex - first, as mentioned, it’s lumpy. You need to take a multi-year average to even that out (depreciation does this for you, so doesn’t face the same issue). The second is that, for growing businesses, much of that capex is related to expansion, not the existing business, so again subtracting it doesn’t really reflect economic reality and results in a number that understates profitability.
Depreciation accounts of the cost of the PPE when it is used, rather than when it is bought. The result is that it better reflects steady-state profitability.
There are problems with depreciation too, of course. Spending money now is worse than spending it over the next 5 years due to the time value of money, so depreciation can give a flawed view of the economics / IRR. Also, yes, the money can be spaffed away on capex that doesn’t turn a profit so destroys shareholder value, and the income statement won’t immediately reflect that loss. However, it will recognise it over the lifetime of the project it was spent on - whether that reflects economic reality better than recognising the loss immediately is basically a philosophical question. But what is not in doubt is that subtracting all capex, treating it effectively like a loss regardless of whether it’s being wasted, is a worse solution.
The best way to deal with things on the capex front is to estimate average maintenance capex, and subtract this. That’s what Buffett uses in his owner earnings calculation.
Sorry for the long ass comment. But the headline point is - yes, FCF over the lifetime is what ultimately determines the value of the business - but current FCF is often not a good indicator of profitability, and hence P/FCF is for many businesses not a useful valuation metric.
And also intangible assets- IP, trade secrets, brand
Perhaps we shall do more research on the topic " Net Income Vs FCF".
Below is one of the research done by FASB.
.
Book 39:
.
FASB was right: Earnings beat cash flows when predicting future cash flows
.
Ray Ball† Valeri Nikolaev‡
December 2020
.
Download Link:
.
https://business.columbia.edu/sites/default/files-efs/imce-uploads/CEASA/Events%20Page/fasb_earnings_beat_cash_flows_when_predicting_future_cash_flows.pdf
You say, "FCF is hard to fake."
I say, "Not so fast!"
The cash flow statement captures a snapshot in time.
Imagine I buy cans of Coca Cola for 50c and sell them for $1. Now imagine I pay my supplier in arrears but collect from customers today - a nice working capital situation.
My cash flow statement today shows only money coming in - there is no cash outflow yet. So today, my cash flows look great.
When I pay my supplier, the cash flows don't look quite so good anymore - even though nothing really changed.
Now consider stock based comp. It is added back to net income as a "non-cash" expense!! If it isn't a cost what is it?
Companies are playing games with the same deferral mechanism I described with reference to the Coca Cola cans.
To make matters worse, the true cost will invariably be multiples higher at the time of vesting, so the recorded cost is wholly unreliable.
So Operating Cash Flows are often unreliable numbers - yet they are a primary input into FCF.
So FCF is very often unreliable.
Back to your statement "FCF is hard to fake" - perhaps you would you like to reconsider?
You raise thoughtful points - but I still stand by the statement: “FCF is hard to fake.” Not impossible, but hard. Let me explain...
You're absolutely right that working capital timing, especially favorable payment terms (paying suppliers later, collecting from customers early), can distort cash flows in a specific period. But over time, these effects normalize. Deferred payables eventually get paid, and receivables eventually need to be collected. So while FCF can be flattered temporarily, it's much harder to sustain this illusion over multiple periods.
your Coca-Cola analogy highlights this: the timing impact shows up in one reporting period, but not across several. Markets and analysts watching trends over quarters (or years) will easily spot this reversal. It’s a temporary boost - not true free cash flow generation.
On stock-based comp, I agree with you: it’s a real economic cost, despite being labeled “non-cash.” But this is precisely why thoughtful FCF analysis adjusts for it. Sophisticated investors don't take reported FCF at face value - they normalize for dilution, capital intensity, and even aggressive adjustments like SBC.
And importantly, SBC doesn't show up in the cash flow statement at all, so it doesn’t directly inflate FCF unless you blindly use the “Operating Cash Flow - CAPEX” formula without nuance.
so yes, companies can game certain components, but it’s significantly harder to manipulate cash than it is to manipulate accrual-based earnings. FCF may not be perfect, but it’s still a more robust measure of economic reality than net income.
To fake FCF consistently, a company would need to:
1. Stretch payables every quarter (unsustainable)
2. Sell receivables (easy to spot)
3. Underinvest in capex (which shows up eventually in growth shortfalls)
4. Rely heavily on adjustments like SBC (which again, can be accounted for)
In other words, it’s hard to fake (especially over time)
Thanks for contributing to the discussion, James!!! You brought up some excellent points.
When asked about his strategy for turning the company around, Jobs shared the following advice:
“Somebody taught me a long time ago a very valuable lesson which is if you do the right things on the top line, the bottom line will follow. And what they meant by that was: if you get the right strategy, if you have the right people, and if you have the right culture at your company, you’ll do the right products. You’ll do the right marketing. You’ll do the right things logistically and in manufacturing and distribution. And if you do all those things right, the bottom line will follow.”
— Steve Jobs
Top Line : Net Income, ROIC, ROA
Bottom Line : Free Cash Flow, CROIC
CROIC = ROIC × Earning Quality (FCF/Net Income)
ROIC = Net Income ÷ Invested Capital
FCF Activator :
Earning to FCF Mechanism Conversion Efficiency (FCF/Net Income)
= Earning Quality
CROIC = FCF ÷ Invested Capital
Top line is revenue, bottom line is net income. At least those are the standard definitions.
That depends on the angle you look.
In the angle of Profitability:
Gpa : top line
ROA, ROIC: bottom line.
In the angle of Profitability and Cash flowability with net income as numerator:
Top Line : ROIC, ROA
Bottom Line : CROIC, CROA
In the angle of profit margin:
Top line : Gross profit margin
Botton line : net profit margin
In the angle of profit:
Top line : Gross profit
Botton line : Net profit
As I said, the definitions I gave are the standard meaning in common parlance. Top line and bottom line refer to the lines of the income statement, where revenue is at the top and income at the bottom.
Why companys stock price rise when there is growth in PAT or EPS? and often this information is looked by general population for investing?
I’m 100% with you on this, JR! Both are absolutely essential.
FCF tells you what’s available; ROIC tells you how efficiently it’s being used.
The key point is: investing millions in working capital and CAPEX just to boost EPS or something similar isn’t enough. Net income on its own doesn’t cut it - it needs to be creating value over time. Otherwise, it truly doesn’t matter.
Relatively, Net Income is Top Line or Mother, and OCF & FCF are the Bottom Lines or Son and Grandson.
When the mother is rich, so does her the descendants, usually.