CapEx effect on Free Cash Flow

Let’s take a look at variations in the level of Free Cash Flow, in an “extreme use case”: telecom giant Verizon.

Verizon’s free cash flow dropped very dramatically from a level of nearly $24B in 2020, to just over $14B in 2022, a decrease of $9.5B in absolute terms, and 40% in relative terms.

Since then, free cash flow has partially recovered. From 2022 to 2024, it went up by $5.7B to nearly 20 billion dollars. That’s an increase of… 40%.

⏱️TIMESTAMPS⏱️
00:00 Free cash flow case study
01:14 What free cash flow is used for
02:01 Free cash flow and enterprise value
03:01 Free cash flow calculation
04:36 Reinvestment ratio

Be careful with the math here. A 40% drop, followed by a 40% increase, does not get you back to the original amount! 23.6 billion dollars times 0.6 gets you to 14.1 billion dollars. If you multiply this lower base number of 14.1 by 1.4, you “only” get to 19.8 billion dollars! It’s all about which number you apply the percentage change to.

Why are variations in the level of free cash flow such a big deal? Let’s zoom out to the big picture. Companies use Free Cash Flow to: pay dividends to shareholders, buy back shares, pay down debt, and to make acquisitions.
In the case of Verizon, the main two in this list are dividends and debt repayment. At Verizon, dividends are a very constant and ever increasing cash outflow, and consume more than half of the free cash flow each year. Dividends went up from $10.2B in 2020 to $11.2B in 2024, an increase of about 200 million dollars per year. These dividend commitments require some stability in free cash flow generation.

For stock market analysts, #freecashflow is a major input into their financial models, which in the end spit out a target share price, and a buy or sell recommendation for the stock. In order to calculate the enterprise value of the company (which is the sum of the value of the borrowings, and the market value of the equity), you could use a very simplistic approach to come up with a ballpark number: take the free cash flow of the current year, and divide it by a discount rate that is appropriate for the company.
Based on 2020’s free cash flow, that enterprise value calculation would have assigned a value of $340B to Verizon.
Based on 2022, just $200B.
Based on 2024, $280B. Based on Verizon’s guidance for future free cash flow, that 2024 number should be the most representative.

So where does the variation in free cash flow levels come from? Free cash flow equals cash from operating activities, minus capital expenditures. Cash from operating activities, in turn, is influenced by revenue, expenses, changes in working capital, etcetera. CFOA did decrease from 2020 to 2022 by 4.6 billion dollars, or 11%. Since then, it has stayed around that level. But those CFOA fluctuations only explain a small part of the total free cash flow fluctuation.

Capital expenditures increased very significantly from 2020 to 2022: by $4.9B, or 27%. The narrative that Verizon provides for this, is an acceleration of their 5G technology deployment. Rather than spreading the investment over multiple years, Verizon chose to go for a peak in #CapEx spending, in order to preserve its competitive position.

Since the peak of 2022, CapEx spending has come back down to a level of 17 billion dollars in 2024, a decrease of 6 billion dollars, or 26%. Once again, beware of the math: a 27% increase, followed by a 26% decrease, does not get you back to the original amount! It all depends on the base number that you apply the percentage to.

Let’s put the level of capital expenditures in perspective, by looking at the reinvestment ratio. Dividing CapEx by depreciation and amortization, gets you to that reinvestment ratio. For every dollar of depreciation and amortization, how many dollars of CapEx are spent? As much as $1.35 in 2022, and as little as $0.96 in 2024. The average for the five years is $1.14.

If you are in charge of the capital expenditures budget, then remember that low variation in the reinvestment ratio can help create Free Cash Flow stability. That’s useful in cases when financial constraints drive a company’s capital expenditures levels. When corporate strategy drives capital expenditures, then CapEx levels are the output metric, and free cash flow variability is simply… a fact of life.

Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, livestreams, classroom sessions, and webinars. Connect with me through Linked In!

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