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Adjusted long term free cash flow

What Is Adjusted Long-Term Free Cash Flow?

Adjusted Long-Term Free Cash Flow refers to a refined measure of the cash a company generates over an extended period, beyond what is required to maintain or expand its asset base, with specific modifications made to its calculation. It falls under the broader category of Financial Analysis and Corporate Finance, serving as a crucial metric for evaluating a company's long-term financial health and its capacity to generate surplus cash. Unlike basic Free Cash Flow (FCF), which provides a snapshot of current cash generation, Adjusted Long-Term Free Cash Flow often incorporates specific adjustments to account for non-recurring items, extraordinary events, or to normalize cash flows for better comparability over a multi-year horizon. This metric offers insights into a company's ability to distribute funds to shareholders, repay Debt, or fund future growth initiatives without external financing.

History and Origin

The concept of free cash flow as a valuation tool gained prominence in the financial world as analysts sought to look beyond traditional accounting profits, such as Net Income, which can be influenced by non-cash charges and accounting conventions. Early proponents of Discounted Cash Flow (DCF) valuation, such as Irving Fisher in the early 20th century and John Burr Williams in 1938, laid the groundwork by emphasizing that the value of an asset is the present value of its future income streams.,5

As financial analysis evolved, the need for a more robust measure of a company's true cash-generating ability led to the development of Free Cash Flow. The "adjusted" and "long-term" components emerged as analysts and investors recognized that a single year's FCF might be distorted by cyclical patterns, large one-time Capital Expenditures, or other unique events. Therefore, practitioners began to make specific adjustments and project cash flows over a longer time frame (e.g., 5-10 years or more) to arrive at a normalized, forward-looking view of a company's sustainable cash generation. The Securities and Exchange Commission (SEC) has also provided guidance on the use of non-GAAP financial measures, which would include many "adjusted" metrics, emphasizing the need for clear reconciliation to Generally Accepted Accounting Principles (GAAP) measures and avoiding misleading presentations.4

Key Takeaways

  • Adjusted Long-Term Free Cash Flow provides a refined, forward-looking view of a company's sustainable cash-generating capacity after accounting for necessary business investments and specific normalizing adjustments.
  • It serves as a critical input in Valuation models, particularly Discounted Cash Flow (DCF) analysis, to estimate a company's intrinsic value.
  • The adjustments typically remove non-recurring or non-operating items to present a clearer picture of a company's core operational performance over an extended period.
  • A robust Adjusted Long-Term Free Cash Flow indicates a company's financial flexibility to repay debt, distribute cash to shareholders, or reinvest for future growth.
  • Accurate forecasting of this metric requires a deep understanding of a company's business model, industry dynamics, and future strategic plans.

Formula and Calculation

Adjusted Long-Term Free Cash Flow typically starts with Free Cash Flow (FCF) and then incorporates additional adjustments for specific items to provide a more representative view of sustainable cash generation over the long term. While there isn't one universal "adjusted" formula mandated by accounting standards, a common approach for calculating Free Cash Flow to the Firm (FCFF), which is often the basis for long-term projections, begins with earnings before interest and taxes (EBIT) or net operating profit after tax (NOPAT) and accounts for non-cash expenses, changes in working capital, and capital expenditures.3,

A generalized formula for Free Cash Flow to the Firm (FCFF), which can then be "adjusted" for long-term analysis, is:

FCFF=EBIT×(1−Tax Rate)+Depreciation+Amortization−Capital Expenditures−Change in Working Capital\text{FCFF} = \text{EBIT} \times (1 - \text{Tax Rate}) + \text{Depreciation} + \text{Amortization} - \text{Capital Expenditures} - \text{Change in Working Capital}

Where:

  • (\text{EBIT}) = Earnings Before Interest and Taxes, representing a company's profitability before interest and income tax expenses.
  • (\text{Tax Rate}) = The company's effective corporate tax rate.
  • (\text{Depreciation}) = The expense recognized for the reduction in value of tangible assets over time.
  • (\text{Amortization}) = The expense recognized for the reduction in value of intangible assets over time. Both Depreciation and Amortization are non-cash expenses.
  • (\text{Capital Expenditures}) = Cash spent on acquiring or upgrading physical assets, such as property, plant, and equipment.
  • (\text{Change in Working Capital}) = The change in current assets minus current liabilities, excluding cash and marketable securities. This reflects the cash tied up or released from operations due to changes in Working Capital.

The "Adjusted" aspect comes into play when analysts modify this base FCFF calculation to remove non-recurring items or normalize certain expenses for long-term forecasting. For example, if a company had a significant one-time gain from an asset sale or an unusual litigation expense, these might be adjusted out of the historical Free Cash Flow to better project a normalized long-term trend. The specific adjustments made depend on the analyst's judgment and the purpose of the Financial Modeling exercise.

Interpreting the Adjusted Long-Term Free Cash Flow

Interpreting Adjusted Long-Term Free Cash Flow involves assessing the sustainability and predictability of a company's cash generation over an extended horizon. A consistently positive and growing Adjusted Long-Term Free Cash Flow generally indicates a financially healthy business capable of self-funding its operations and growth, repaying Debt obligations, and returning value to shareholders through dividends or share buybacks.

Conversely, a declining or negative Adjusted Long-Term Free Cash Flow over a prolonged period could signal underlying issues. This might include excessive Capital Expenditures that aren't yielding sufficient returns, deteriorating operational efficiency leading to lower cash from Operating Activities, or an inability to manage Working Capital effectively. It's crucial to analyze the specific adjustments made, as they can significantly impact the final figure. Understanding the rationale behind these adjustments helps in evaluating whether the projected cash flows are realistic and reflective of the company's true long-term potential. This metric, when properly interpreted, provides a deeper insight into a company's financial resilience than simpler profitability measures.

Hypothetical Example

Consider "InnovateTech Inc.," a rapidly growing software company. For the past five years, InnovateTech has shown strong revenue growth. However, in Year 3, the company made a very large, one-time acquisition of a competitor for $50 million, which significantly impacted its Free Cash Flow for that year due to the high Capital Expenditures and associated integration costs.

An analyst performing a long-term Valuation of InnovateTech needs to project its sustainable cash flows. If they only look at the raw Free Cash Flow, Year 3 would appear as an anomaly, potentially skewing the long-term trend.

Here’s how Adjusted Long-Term Free Cash Flow would be applied:

Scenario:

  • Year 1 FCF: $10 million
  • Year 2 FCF: $15 million
  • Year 3 FCF (with acquisition): -$30 million (due to $50 million acquisition CapEx)
  • Year 4 FCF: $20 million
  • Year 5 FCF: $25 million

To calculate InnovateTech's Adjusted Long-Term Free Cash Flow, the analyst decides to adjust for the one-time acquisition in Year 3. They determine that without this extraordinary CapEx, InnovateTech's FCF in Year 3 would have been approximately $20 million, reflecting its underlying operational cash flow generation.

Adjusted FCF:

  • Year 1 Adjusted FCF: $10 million
  • Year 2 Adjusted FCF: $15 million
  • Year 3 Adjusted FCF: $20 million (Original -$30M + $50M acquisition CapEx added back)
  • Year 4 Adjusted FCF: $20 million
  • Year 5 Adjusted FCF: $25 million

By making this adjustment, the analyst gains a clearer picture of InnovateTech's normalized, sustainable cash-generating ability over the long term, which shows a consistent positive trend rather than a sharp dip caused by a non-recurring event. This adjusted series is then used for future projections in a Discounted Cash Flow model.

Practical Applications

Adjusted Long-Term Free Cash Flow is a cornerstone in various aspects of Financial Analysis and decision-making within investing and corporate strategy.

  • Equity Valuation: One of its primary uses is in Discounted Cash Flow (DCF) models, where future Adjusted Long-Term Free Cash Flows are projected and then discounted back to the present to estimate a company's intrinsic Equity value. This is particularly favored by analysts, with a study noting that 86.9% of analysts using DCF models utilize a discounted free cash flow approach. B2y normalizing the cash flows, analysts can derive a more reliable estimate of a company's true worth, less susceptible to short-term fluctuations or unusual events.
  • Capital Allocation Decisions: Corporate management utilizes Adjusted Long-Term Free Cash Flow to make informed decisions about how to allocate capital. A strong, predictable long-term cash flow stream indicates the capacity for reinvestment in the business (e.g., research and development, new projects), debt repayment, or returning capital to shareholders through dividends or share buybacks.
  • Mergers and Acquisitions (M&A): In M&A deals, prospective buyers use Adjusted Long-Term Free Cash Flow projections to determine the target company's value. By assessing the normalized, long-term cash-generating potential, buyers can justify the acquisition price and assess the financial synergies.
  • Credit Analysis: Lenders and credit rating agencies analyze a company's Adjusted Long-Term Free Cash Flow to gauge its ability to service and repay Debt over time. A robust and stable long-term cash flow provides comfort regarding a company's financial solvency.
  • Strategic Planning: Companies use projections of Adjusted Long-Term Free Cash Flow in their strategic planning processes. Understanding future cash availability helps in setting growth targets, planning for market expansion, or anticipating funding needs. Macroeconomic forecasts, such as those provided by the OECD Economic Outlook, can influence assumptions made for these long-term cash flow projections, especially regarding overall economic growth and industry trends.

Limitations and Criticisms

While Adjusted Long-Term Free Cash Flow is a powerful analytical tool, it is not without limitations and criticisms. Its effectiveness hinges significantly on the accuracy of the underlying assumptions and projections.

One major challenge lies in forecasting cash flows accurately over a long period. Future economic conditions, industry trends, competitive landscapes, and a company's operational performance can deviate significantly from initial assumptions, leading to potentially inaccurate Adjusted Long-Term Free Cash Flow projections. As the projection horizon extends, the uncertainty compounds, making the long-term estimates highly sensitive to small changes in growth rates or margins.

Furthermore, the "adjusted" nature of the metric introduces subjectivity. Analysts may choose different adjustments based on their interpretation of what constitutes a "normal" or "recurring" cash flow. For instance, determining whether certain Capital Expenditures are for maintenance or growth can be complex and impact the resulting Free Cash Flow figure. This subjectivity can make it difficult to compare Adjusted Long-Term Free Cash Flow across different companies or even different analyses of the same company. The Securities and Exchange Commission (SEC) has consistently issued guidance on non-GAAP financial measures, highlighting concerns about potentially misleading adjustments that exclude normal, recurring, cash operating expenses.

Lastly, like any forward-looking financial metric derived from Financial Statements, Adjusted Long-Term Free Cash Flow is a projection and not a guarantee of future performance. It relies on a multitude of assumptions, and if these assumptions prove incorrect, the resulting valuation or analysis based on Adjusted Long-Term Free Cash Flow will also be flawed. Investors should always consider this metric in conjunction with other qualitative and quantitative factors, recognizing its inherent reliance on estimations.

Adjusted Long-Term Free Cash Flow vs. Free Cash Flow (FCF)

The terms Adjusted Long-Term Free Cash Flow and Free Cash Flow (FCF) are closely related but serve slightly different purposes in financial analysis. The key distinction lies in the temporal aspect and the application of specific "adjustments."

Free Cash Flow, in its most common definition, represents the cash a company generates from its Operating Activities after accounting for the Capital Expenditures necessary to maintain its asset base. It is typically calculated for a specific past period (e.g., a fiscal year or quarter) using information from the company's Income Statement and Balance Sheet, and it reflects the cash available today to all capital providers., 1FCF can be volatile from year to year due to large, infrequent capital outlays or unusual operational events.

Adjusted Long-Term Free Cash Flow, on the other hand, is a forward-looking concept that aims to smooth out and normalize these potential year-to-year fluctuations in FCF. It involves projecting Free Cash Flow over an extended period (e.g., 5, 10, or more years) and making specific "adjustments" to the historical or projected figures. These adjustments might involve removing the impact of one-time asset sales, extraordinary legal settlements, or exceptionally large capital projects that are not expected to recur regularly. The goal of Adjusted Long-Term Free Cash Flow is to arrive at a more representative and sustainable measure of a company's long-term cash-generating capacity, making it particularly useful for long-term Valuation models like the Discounted Cash Flow (DCF) method.

In essence, FCF is a historical measure that can be "lumpy," while Adjusted Long-Term Free Cash Flow is a normalized, forward-looking projection designed to provide a clearer view of a company's consistent ability to generate cash for its stakeholders over time.

FAQs

Q: Why is "adjusted" Free Cash Flow important for long-term analysis?
A: Adjusted Free Cash Flow is important for long-term analysis because it helps to normalize a company's cash flow stream by removing the impact of non-recurring or unusual events. This provides a clearer picture of the company's sustainable cash-generating ability, which is crucial for accurate long-term Valuation and strategic planning.

Q: How do analysts typically "adjust" Free Cash Flow?
A: Analysts may adjust Free Cash Flow by adding back or subtracting non-recurring items that are not expected to impact future periods. Examples include large one-time asset sales, extraordinary legal settlements, or significant non-operational Capital Expenditures like a major acquisition. The goal is to arrive at a normalized figure that reflects core operations.

Q: Is Adjusted Long-Term Free Cash Flow a GAAP measure?
A: No, Adjusted Long-Term Free Cash Flow is generally considered a non-GAAP (Generally Accepted Accounting Principles) financial measure. It is a custom metric used in Financial Analysis that allows analysts to tailor the calculation to their specific valuation needs, as it provides a cash-centric view of performance. Companies are required by the SEC to reconcile non-GAAP measures to their most directly comparable GAAP measures.

Q: What is the relationship between Adjusted Long-Term Free Cash Flow and Discounted Cash Flow (DCF) models?
A: Adjusted Long-Term Free Cash Flow is a fundamental input for Discounted Cash Flow (DCF) models. In a DCF analysis, these projected adjusted cash flows are discounted back to their present value using an appropriate discount rate, such as the weighted average cost of capital, to determine the intrinsic value of a company's Equity or the firm.