Free Cash Flow

Net income is an accounting concept that can be distorted by non-cash items (D&A, stock-based comp, deferred taxes) and aggressive revenue recognition. FCF measures actual cash generation. A company can report strong net income while burning cash — or vice versa. Amazon famously reported negative net income for years while generating positive FCF. In banking and investing, cash is king, and FCF is how you measure it.

Levered FCF (FCFE) = Net Income + D&A - CapEx - Change in NWC + Net Borrowings. It represents cash available to equity holders after debt service. Unlevered FCF (FCFF) = EBIT x (1 - Tax Rate) + D&A - CapEx - Change in NWC. It represents cash available to all capital providers (debt + equity) before debt payments. Unlevered FCF is used in DCF models because it is capital-structure-neutral, while levered FCF is used in equity valuation and dividend analyses.

FCF Yield = FCF per Share / Share Price. It measures how much cash a company generates relative to its market value. A higher FCF yield generally indicates a cheaper stock. Activist investors often target companies with high FCF yields and low reinvestment rates, arguing the company should return more cash to shareholders via buybacks or dividends. In PE, entry FCF yield is a key metric — buying at a 10% FCF yield is more attractive than 5%, all else equal.

In leveraged buyouts, FCF is the primary driver of returns because it determines how quickly the PE firm can pay down debt. An LBO target with $100M EBITDA but only $30M of FCF (due to heavy CapEx and working capital needs) is far less attractive than one with $70M of FCF. PE firms often project FCF under different scenarios to stress-test the downside — 'Can this company service its debt even in a recession?'