We had a listener of our podcast commenting on our free cash flow comments that we have been making over the past year. The person had two objections to our methodology, 1) we are not adjusting for stock options which are massively used by technology companies to attract talent and reduce the cash burn rate, and 2) we are not adjusting free cash flow for acquisitions which many technology companies are doing instead of investing in R&D themselves.
The objection is true, and the free cash flow should be corrected by stock options and warrants. But how big a difference does it make? Many of the largest constituents in the Nasdaq 100 Index have stock options corresponding to around 1-4% dilution of the current outstanding shares and thus including this dilution would make the metric more correct, but it would not alter the overall conclusion.
The second objection is interesting. Industry practice suggests to only subtract capital expenditures from the operating cash flow to get to the free cash flow (the cash flow that is available for acquisitions, debt reduction, buybacks of own shares, or dividends), because it is more stable and provides a more realistic picture of the underlying free cash flow generation. Large acquisition or divestments would make the free cash flow yield very volatile and clutter the analysis. The adjustment for acquisitions makes sense if an investor could expect acquisitions to be consistent, but that is very rare for most companies and as such we acknowledge the potential adjustment, but we do find it adds value for the investment decision process on equity indices.