Free cash flow — what you actually discount

In the last module you learned that a rupee next year is worth less than a rupee today, and that a discount rate — the yearly rate you shrink future money by — turns tomorrow's cash into today's value. That leaves one large question unanswered: which future money?

It is tempting to say "the profits". Almost every beginner starts there, because profit is the number the headlines quote and the number the company boasts about. But profit is not what an owner can spend, and a valuation is only ever about what an owner can spend. This module is about finding the honest number — the cash a business actually throws off after it has paid for everything it needs just to keep going. Get this number wrong and every clever discounting sum that follows is built on sand.

Net profit — the "bottom line" — looks solid, but it is assembled from judgements. Depreciation spreads the cost of a machine over many years using an assumption about how long it lasts. Revenue can be booked before the customer has paid. A provision for a future cost lowers profit today though no cash has moved. None of these are dishonest; they are how accrual accounting works. But they mean the profit figure is, in a real sense, an opinion about how to slice up time and cost.

Cash is harder to argue with. Either money came in the door or it did not. This is why serious valuation starts from the operating cash flow — the cash a business generated from its actual operations in a year, taken straight from the cash-flow statement, after adding back non-cash charges and adjusting for money tied up in inventory and receivables. Operating cash flow is often higher than net profit, because big non-cash expenses like depreciation are subtracted to get profit but never actually left the company.

The value of any business is the cash it will hand its owners over its life, discounted back to today — that is the whole idea behind a DCF, first written down by John Burr Williams in 1938. But "cash it will hand its owners" is not the same as operating cash flow, because a business cannot hand out every rupee it earns. Some of that cash must go straight back into the business just to keep it standing. What is left after that is the number we are after.

Warren Buffett gave the cleanest name for the honest number: owner earnings — the cash an owner could pull out of the business each year without weakening its ability to earn the same amount next year. It is the money that is truly free, once the business has been kept whole.

To get there, you split the company's spending on plant, machines and other long-lived assets — its capital expenditure, or "capex" — into two very different kinds:

• Maintenance capex is the spend needed just to stand still: replacing worn-out machines, renewing the fleet, keeping the current earning power intact. This is not optional. Skip it for a few years and the business quietly decays.
• Growth capex is the spend that adds new capacity — a second factory, a new product line. It is a choice, and it buys future earnings, not today's.

The formula for owner earnings is deliberately simple:

Owner earnings = Operating cash flow − Maintenance capex

Notice what is not subtracted: growth capex. Growth spend is left in, because an owner could choose to stop growing and pocket that money without harming the current business. Owner earnings ask a precise question — what is this business earning, as it is, right now?

Let's put real numbers on it. illustrative

Two honest numbers fall out of the same business. Owner earnings of ₹90 crore measure what it earns as it stands. Free cash flow of ₹50 crore — operating cash flow minus all capex — is what is left in a year when the owner also chooses to grow. Neither is wrong; they answer different questions. For valuing the business as it is today, owner earnings is the cleaner input; when you model growth explicitly in a DCF, you subtract the growth capex too and forecast the higher cash flows it buys. The trap is to confuse the two, or to reach for net profit and skip the cash question entirely.

Take a mid-sized manufacturer. illustrative Its results boast a record net profit of ₹80 crore. A beginner types 80 into a DCF and moves on. Look what that skips.

The cash-flow statement shows ₹35 crore of depreciation — a real cost in the profit line, but no cash actually left, so it is added back. A little more cash, ₹5 crore, got tied up in extra inventory and unpaid customer bills this year, so that is taken out. Operating cash flow lands at ₹120 crore — half as much again as the reported profit. Already the "obvious" number was ₹40 crore too low.

Now the harder judgement. The company spent ₹70 crore on capex. How much of that just kept the lights on, and how much built new capacity? The accounts rarely split it for you, so you estimate — from the notes, from management commentary, from how fast depreciation is running. Say ₹30 crore was replacement and renewal, and ₹40 crore was a new line. That gives owner earnings of ₹90 crore (₹120 − ₹30) and free cash flow of ₹50 crore (₹120 − ₹70).

The point that matters: the same company honestly produces ₹80 crore (profit), ₹120 crore (operating cash), ₹90 crore (owner earnings) and ₹50 crore (free cash flow). Which one you feed the DCF changes the answer enormously — and choosing it is a judgement, not a lookup.

Free cash flow is the honest input, but it hides real dangers, and this section is where we say so plainly.

The maintenance-growth split is a guess. Companies almost never disclose it. You infer it, and a management team keen to look asset-light has every reason to call replacement spending "growth". Push maintenance capex down and owner earnings jump — on paper. The number that feels most factual rests on one of the softest judgements in the whole exercise.

One year is noise. Working capital swings, a delayed tax payment, a lumpy capex year — any of these can make a single year's free cash flow wildly unrepresentative. A business can post negative free cash flow in a heavy build-out year and be perfectly healthy, or post flattering free cash flow simply by starving itself of needed investment. You must read several years and normalise, never trust one.

Free cash flow is silent on quality and price. A rich cash flow tells you nothing about whether the earnings will last, whether a competitor is about to erode them, or whether the stock is cheap. It is an input to a valuation, not a verdict on one. A cash-flow figure without a business story behind it is just a number waiting to fool you — the story is what tells you whether ₹90 crore is durable or about to fade.

The same handful of slips catch beginners again and again.

1. Discounting profit instead of cash. The headline number is an accounting opinion. A DCF wants cash the owner can keep.

2. Forgetting maintenance capex. Discounting the full operating cash flow, as if machines never wear out, quietly inflates value. Something must be left behind to stand still.

3. Calling all capex "growth". The softest, most flattering assumption in the book. Every rupee reclassified from maintenance to growth lifts owner earnings without a single thing changing in the real business.

4. Trusting one year's number. A lumpy capex year or a working-capital swing can make free cash flow meaningless in isolation. Normalise across a cycle.

5. Ignoring where the cash actually goes. Cash that never reaches shareholders — endlessly reinvested at poor returns, or lost to dilution — is not really "free" to you, however healthy the headline looks.