Earnings vs Free Cash Flow

Earnings, in traditional accounting terms, only shows how much a business earned. It doesn’t consider the additional capital invested to achieve the earnings. Free cash flow is the true earnings to the owners.

Two businesses that are generating same earnings and likely to grow at the same rate shouldn't be valued the same. Earnings and earnings growth alone don't determine the value of a business ownership. Additional capital invested to achieve the growth also matters. A business that can achieve the same growth as the other business without significant additional capital is much superior.

For example, Business A and Business B are expected to generate $150 in earnings each next year from current base of $100. Business A has to spend $50 additional capital to achieve the growth while Business B doesn't need additional capital. Business A issues new shares to raise additional capital which dilutes the ownership of the existing shareholders or takes on debt which increases the risk of the business. Meanwhile, Business B can share the growth in earnings with shareholders as they don't need additional capital to grow. We are looking at two different kinds of businesses even if their earnings and growth are the same. Free cash flow (earnings net of additional capital invested) is the true earnings to the owners.