Earnings and Cash Flows: A Primer on Free Cash Flow

This article provides a comprehensive primer on free cash flow (FCF), distinguishing between free cash flow to equity (FCFE) and free cash flow to the firm (FCFF), and explaining how each should be calculated and applied in different contexts. The author demonstrates that FCF calculations vary significantly depending on whether the goal is explaining past performance, conducting intrinsic valuation, or pricing companies, and illustrates these concepts using Microsoft as a detailed case study. The article concludes that while FCF is conceptually superior to earnings for understanding business health, it is too volatile to be practical as a pricing multiple compared to traditional PE ratios or EV/EBITDA.