The importance of free cash flow

Free cash flow (FCF) is a fundamental component of intrinsic valuation. It essentially represents the amount of funds remaining from operating cash flow once the capital expenditure required to maintain or grow its asset base is accounted for. The FCF to equity is effectively cash that belongs to the owners of the business (the shareholders) which is then available to be paid out as dividends, used to reduce the company’s debt, fund any acquisitions or repurchase shares via a buyback programme. This important metric also indicates whether any planned investments can be sustained from ongoing operations or whether fresh capital is required.

A company’s free cash flow can be volatile from one year to the next and is very much dependent on the corporate lifecycle and investment phase of the business.

The free cash flow yield

Many of the world’s most renowned investors and fund managers regularly refer to a company’s free cash flow yield when screening the equity markets for investment opportunities.

The free cash flow yield compares the free cash flow to the market capitalisation of the company. Most international investors use the FCF yield rather than the price to earnings multiple or the dividend yield to assess the attractiveness of a business. Naturally, the higher the yield, the greater the cash return an investor is theoretically receiving relative to what they are paying for the business via the share price.

A high free cash flow yield may signal the following (i) that the market is undervaluing a business relative to its cash-generating capacity; (ii) that the business operates in a low-growth industry where high cash conversion is normal; (iii) that the market is pricing in a deterioration in future cash flows which is not yet reflected.

On the other hand, a low FCF yield may indicate that a company is being priced for strong future growth (typical for technology companies) or that capital expenditure is elevated in the short term due to an investment cycle, temporarily compressing the yield without any structural impairment to the underlying business quality.

Many investors believe that this is a better valuation multiple as opposed to the price to earnings multiple (based on the earnings per share) or the enterprise value to EBITDA multiple since profitability can at times mislead investors due to various accounting standards and some non-cash items (mainly depreciation and amortization).

As with all other metrics, however, financial analysts must place the FCF yield within the context of the actual company or industry dynamics being reviewed. Other multiples and valuation models should also be used before drawing upon any investment conclusions.

The domestic market through a cash flow lens

A number of companies whose equity is listed on the MSE are dominant in their respective sectors with long track records and visible revenue streams where cash conversion, the extent of capital expenditure and dividend sustainability are the main factors that investors and analysts should consider. The importance of the FCF and the FCF yield can be seen from three specific companies passing through very different stages in their lifecycle, namely Malta International Airport plc, GO plc and MedservRegis plc.

MIA is in the midst of a very heavy capital expenditure programme spanning several years as the company embarks on a major terminal expansion project and the development of SkyParks 2. In fact, in view of capital expenditure amounting to just under €70 million in 2025, the company had a negative free cash flow last year. The airport operator will undoubtedly continue with such a high level of capital expenditure for a few more years given the extent of their strategic plans. However, this is largely expansionary and one would expect much higher operating cash flows in the future once the various phases of the current programme is completed especially if passenger traffic remains strong. Moreover, once there is a normalisation of capital expenditure, MIA’s FCF yield should recover sharply. Given the investment philosophy and requirements of many retail investors, it may prove to be difficult for them to look past the current investment phase and continue to wait for the higher cash generation ahead.

Meanwhile, GO has very recently completed its major investment of fibre-to-the-home across the Maltese islands which was the dominant driver of the elevated capital expenditure over recent years. In 2025, GO reported that its capex declined to €42 million from over €66 million in the previous year. The free cash flow improved to €30 million (excluding acquisitions) which is an important determinant of the sustainability of the recent dividend distributions.

The business of MedservRegis is very much project-based and following the very challenging conditions over the past decade, the recent strong financial turnaround reported by the company may take time to be fully appreciated by market observers. The company has now reportedly entered into a number of multi-year contracts which should enable it to deliver consistent free cash flow going forward. Over the last two financial years, the company generated an average free cash flow of €3.7 million giving a yield of 5% based on a current market capitalisation of around €70 million. Medserv’s forecasts for 2026 show a material increase in the expected cash flow from operating activities and a reduction in capital expenditure, which would translate into higher levels of free cash flows. These are anticipated to result in a higher cash balance of over €22 million at the end of 2026 and lower levels of debt.

What has happened to the hyperscalers

For many years, some of the largest US technology companies such as Alphabet, Amazon, Microsoft and Meta had very high cash-generative business models. A large part of their revenue was converted into free cash flow which enabled them to fund enormous share buy-back programmes producing stellar returns for investors.

However, the very handsome free cash flow generation has evaporated as a result of the extraordinary capital expenditure in AI by these hyperscalers. A number of industry analysts expect the free cash flow of a number of the large technology companies to reach their lowest level in over a decade when their revenue generation was significant lower. By way of example, Alphabet’s free cash flow could fall to USD8.2 billion by 2027 from USD73.3 billion in 2025 and Amazon is expected to consume more cash than it generates.

This has necessitated a change in capital allocation. Meta suspended its share buyback and issued USD55 billion of debt over the past six months. Alphabet increased its capital by USD85 billion via new equity and convertible instruments, supplemented by a USD10 billion private placement. Total debt issuance by the hyperscalers is anticipated to reach USD175 billion this year compared to a five-year average of USD28 billion.

Although the profitability of these large technology companies has generally remained strong, their free cash flow has evaporated. As such, the price to earnings multiple would project one image while the FCF yield depicts the reality of the huge emphasis on the AI infrastructure which may not generate the required returns for investors in the future.

This will be one of the major focal points for market commentators as the Q2 earnings season in the US commences this week. While the hyperscalers are under scrutiny due to the intense capital expenditure and the resultant negative impact on FCF, various media outlets are reporting that semiconductor companies are huge beneficiaries of this as Nvidia, Micron, Broadcom and Applied Materials are now expected to generate a record USD430 billion in combined FCF over the next 12 months, which would be more than triple the FCF they generated only 2 years ago. Semiconductor companies and chipmakers are effectively becoming the ones generating the very strong cash flows while the hyperscalers are burning record amounts of capital. This is one of the main reasons for the strong outperformance of semiconductor companies and chipmakers in recent months.

In view of the importance of free cash flow, it would make sense for equity issuers in Malta to articulate movements and guidance on free cash flow in their occasional communications to the market in order to help educate retail investors and provide the necessary tools to financial analysts to perform their role when valuing companies.

The article contains public information only and is published solely for informational purposes. It should not be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in this article. Rizzo, Farrugia & Co. (Stockbrokers) Ltd (“Rizzo Farrugia”) is under no obligation to update or keep current the information contained herein. Since the buying and selling of securities by any person is dependent on that person’s financial situation and an assessment of the suitability and appropriateness of the proposed transaction, no person should act upon any recommendation in this article without first obtaining investment advice. Rizzo Farrugia, its directors, the author of this article, other employees or clients may have or have had interests in the securities referred to herein and may at any time make purchases and/or sales in them as principal or agent. Furthermore, Rizzo Farrugia may have or have had a relationship with or may provide or has provided other services of a corporate nature to companies herein mentioned. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Foreign currency rates of exchange may adversely affect the value, price or income of any security mentioned in this article. Neither Rizzo Farrugia, nor any of its directors or employees accepts any liability for any loss or damage arising out of the use of all or any part of this article.