As the saying goes, “cash is king”. The new Betashares Global Cash Flow Kings ETF (ASX: CFLO) is hoping to cash in.
What is free cash flow?
Free cash flow refers to the amount of cash a company generates after paying its operational costs and any equipment maintenance or purchases.
The difference between free cash flow and something like net income is that the net income includes “non-cash expenses”. These are accounting costs that don’t represent actual payments, like depreciation.
So, what does free cash flow tell you as an investor?
The easiest way to think about free cash flow is it’s a bit like your own personal finances. Your salary comes in each fortnight (your revenue) and your free cash flow is what you have left over after paying your usual living costs.
It’s easy to imagine why this free cash flow would be useful – it gives you options. You might invest your remaining cash, or maybe you choose to hide it away for a rainy day. Maybe you buy something nice with it.
It’s exactly the same for a company. A company with strong free cash flow also has options – they could pay some of it out to investors as dividends, they could keep it aside for a future investment, or they might decide to spend it on some new equipment or assets.
Is it a good investment metric?
The short answer is yes. Free cash flow is a useful metric when assessing the performance of a company because it gives you insights into the company’s ability to repay debts, pay dividends, and invest in new infrastructure.
Much like your personal expenses, a company with higher free cash flow has more options and is generally in a ‘healthier’ position.
However, there are a few reasons why free cash flow isn’t the best metric to rely on.
The main one is that it can be very inconsistent, or ‘lumpy’.
Imagine a company decides to invest $1 million in a new piece of equipment. On the income statement, this new piece of equipment would be depreciated over, say, 20 years, so it would appear as a $50,000 cost ($1m divided by 20).
However, the free cash flow number would take the full hit of $1m in the year the equipment was bought, then bounce back in the next year. So, a sudden drop in free cash flow may not be cause for concern, it might just mean the company is investing in equipment (which could make it more money in the long-term).
Often times a small fast-growing company will have low or negative free cash flow because they’re investing heavily in their growth. In this case free cash flow might not be a useful measure of their growth potential.
The cash flow kings ETF
The Betashares Global Cash Flow Kings ETF (ASX: CFLO) launched in November last year with the premise that companies with high free cash flow have historically outperformed the market over the medium to long term.
The CFLO ETF invests in 200 companies across more than 10 countries and multiple industries. The ETF aims to track a Solactive index that essentially takes companies from developed global markets and ranks them based on recent free cash flow generation, as well as the consistency and growth of the free cash flow.
There’s a strong representation of US companies (more than 70% of the ETF) and tech companies such as Alphabet Inc (NASDAQ: GOOGL) and Adobe Inc (NASDAQ: ADBE).
Betashares present a number of academic articles in their product brochure that show support for the idea that free cash flow is a useful indicator of future performance, and the benchmark index has performed well over the last 10 years.
I’d always be hesitant to make an investment decision off a single metric, but if you are going to then free cash flow probably isn’t a bad choice.
This is a relatively new ETF which makes it hard to assess what the potential is, but I’d say it’s one to keep an eye on.