Free cash flow used to be a bad thing. What happened?

Research
1

If you look up “free cash flow” on Google Scholar you get a hundred academic papers riffing on Michael C. Jensen’s 1986 papers which, as far as I can see, were the first to use the words “free cash flow.” For Jensen, free cash flow was “cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. Such free cash flow must be paid out to shareholders if the firm is to be efficient and to maximize value for shareholders.” Jensen saw free cash flow as a problem rather than a good thing. “Conflicts of interest between shareholders and management over payout policies are especially severe when the organization generates substantial free cash flow,” he wrote. “The problem is how to motivate managers to disgorge the cash rather than invest it below the cost of capital or waste it through organizational inefficiencies.” For Jensen, free cash flow couldn’t finance growth, since by definition it was excess to the cash flow needed for growth—it was an inefficiency. And all the subsequent academic papers confirm Jensen’s theory.

Discounted cash flow analysis has been around since the 1950s, but they never used the term “free cash flow” until the late 1990s, as far as I can see, and even then they didn’t do so consistently. It was always about “cash flow,” not “free cash flow.”

Now, if you look on the Internet, almost all the mentions of free cash flow are about it being a good thing, not an inefficiency or a problem. Certainly all my backtests show free cash flow as a good thing. What happened to change everything? And when? Does anyone have a clue how free cash flow changed its meaning, or why Jensen and all the other academics see free cash flow as an inefficiency? I’m quite confused.

Thanks,

  • Yuval
2

Perhaps the view was that firms should reinvest all cash into the business, which would result in no FCF. But I would speculate that so called “empire building” might run the risk of investing in marginal projects, which might destroy value. The relatively new “Investment” factor, introduced by Fama and French in 2015, seems to suggest that companies tend to outperform when they are more conservative expanding book assets (relative to peers).

3

Buffett was the first thing that popped into my head when I read your post, but I was only a teenager in 1986 and don’t know the history. Warren Buffett’s advocacy and success had to have some impact as people tried to understand what he was doing.

Per this valuewalk link, they indicated Buffett talked about “owners earnings” first in his 1986 Berkshire letter, and may have led to investors seeking out fcf.

http://www.valuewalk.com/2015/11/warren-buffett-owner-earnings-vs-free-cash-flow/

quote: “Of course, investors as a group tend to have a need for immediate gratification and tend to seek out a single, simple, quick formula for investing. Because of those needs, free cash flow was born as the “armchair investor’s” owner earnings.”

Anyhow, I wanted to post this in case it’s of help.

4

Hmm. Maybe telecom in the late 1990s/early 2000s?

If the theory was that corporate earnings should either be immediately plowed into positive NPV projects or delivered immediately to shareholders, then the idea of a staid utility industry suddenly becoming a high-growth industry probably never occurred to 1980 theorists. (At least I can’t think of another example off the top of my head.)

Then it happened. Suddenly holding funds back for potential use needs to be accounted for and, indeed, rewarded.