Free Cash Flow is defined in a number of different ways as there is not a clearly defined term under the Generally Accepted Accounting Principles (GAAP).
I am going to attempt to explain Free Cash Flow in the best way possible but first why do we care about Free Cash Flow?
In simple terms Free Cash Flow is what is left over after a company pays all cash expenses and makes investments in capital equipment and working capital. So FCF (Free Cash Flow) is after tax cash flow available to all investors.
The way I learnt to calculate Free Cash Flow is start with the revenue and deduct all operating costs, arriving at operating profit. We then apply the tax rate to the operating profit. This gives us the net operating profit less adjusted taxes. To obtain FCF, we add back non-cash operating expenses, then deduct capital expenditures and investments in working capital.
Why do we care about FCF?
Free Cash flow is available to all claimholder’s on a business, both debt holder’s and shareholder’s. We care about Free Cash Flow because it helps us determine the value of company. Free cash flow or FCF helps us calculate the intrinsic value of a company, which we derive by calculating all future cash flows of the company minus the average cost of capital. So if you can buy the shares of a company at a discount to the intrinsic value, you are almost certain to make a profit.
I have learnt a great deal about this topic and other finance topics from the Motley Fool website and from the community boards. There is a lot of talk about Free Cash Flow at the Motley Fool website. Check out the following article on Foolish Fundamentals: Free Cash Flow.
What is Free Cash Flow? and why do we care?
Diversify, Diversify, Diversify
What is the perfect number of stocks to hold in a portfolio?
In my humble opinion, there is no perfect number, it truly depends on the individual and their level of confidence in their own analysis.
For me that perfect number of individual stocks is 20. I will explain how I came to this number in a minute. But first, a Buffet quote to get us started.
"Wide diversification is only required when investors do not understand what they are doing"
Investor's with Warren Buffett's investment acumen can really get a bang out of their buck by only investing in a small number of securities, but for the rest of us, diversification is a necessity. Although, too wide a diversification can work in the opposite way and truly dilute the returns of a portfolio.
So how do you figure out what your magic number is? First you have to agree on the amount of time you can truly spend researching and analyzing the investments that you are going to be investing in. The magic number for me is 20. I can reasonably manage to read about and keep up with about 20 securities.
Here is how I have structured my portfolio. I invested 30% of the total portfolio in the Vanguard Total Stock Market Fund (VTSMX). Since this fund invests in the total stock market, this gives me immediate diversification. The next 10% of the portfolio is in cash and invested in a money market fund. The remainder 60% is invested in 20 stocks, that include blue chips, small caps and mid caps. This comes to an individual investment of only 3% percent in any one company. This gives me a cushion in case one of my stocks take a beating in the short term. If this happens I use the cash in the portfolio to add to my position, bringing down my cost per point on the security.
Here is how the investment portfolio breaks down:
VTSMX 30%
CASH MONEY MARKET 10%
Individual Stocks (20 stocks) 60%
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Total 100%
