Valuation course · Lesson 2 of 10
Net income, free cash flow and owner earnings are three different numbers.
A company can report a profit and still have less cash for its owners. Three items make the difference: stock pay, working capital and equipment.
Four measures of one year
| Measure | $ millions | Per share | Yield at $30 |
|---|---|---|---|
| Net income | 137.5 | $1.37 | 4.6% |
| Cash from operations | 185.1 | $1.85 | 6.2% |
| Free cash flow | 105.1 | $1.05 | 3.5% |
| Owner earnings: free cash flow less stock pay | 90.1 | $0.90 | 3.0% |
Each line answers a different question. Net income follows the accounting rules. Cash from operations counts the cash that came in. Free cash flow subtracts the equipment. Owner earnings also subtract stock pay.
Stock pay is a cost
The company paid $15 million of its pay in stock. The cash flow statement adds it back, because no cash left. But the company issued 0.5 million new shares to the staff, and each old share now owns a smaller part of the company.
So we subtract stock pay again. Free cash flow of $105.1 million becomes owner earnings of $90.1 million. A company that pays more of its staff in stock can show a higher free cash flow without more value for its owners.
Growth uses cash
Example Co. needs working capital of 10% of revenue, for stock and for money that customers owe. Revenue grew 8%, so working capital grew $7.4 million. That cash is in the business, not in the bank.
Capital expenditure was $80 million, and depreciation was $40 million. The difference, $40 million, pays for more capacity. A company that stops growth can stop most of that cost.
Cash flow before interest
A DCF values the whole business, for the lenders and the owners together. So it uses cash flow before interest: operating income after tax, plus depreciation, less capital expenditure and the change in working capital. For Example Co., that is $94.8 million.
The difference from owner earnings is the net interest cost after tax, $4.74 million. The DCF then subtracts the net debt at the end, in lesson 9.
Key points
- Net income is not cash. Start with cash from operations.
- Subtract capital expenditure for free cash flow, and stock pay for owner earnings.
- A DCF uses cash flow before interest, and subtracts net debt at the end.