The Free Cash Flow Mirage: How Companies Inflate Earnings and Mislead Investors

Open any accounting or corporate finance textbook, and you’ll see a simple definition: Free Cash Flow (FCF) = Operating Cash Flow (OCF) – Capital Expenditures (Capex).

So why does the corporate world rarely follow this definition?

Take Rogers Communications’ latest earnings report as an example. In their Q4 press release, the company proudly highlighted over $3 billion in free cash flow. But a closer look reveals a different story. Its reported figure includes a laundry list of add-backs: restructuring expenses that seem to show up year after year, working capital changes that consistently drag down available cash, and the omission of lease payments for office space, warehouses, and vehicles. The true free cash flow number, once you strip out these adjustments, sits closer to $1.2 billion, less than half the stated amount. That’s the real number available for dividends, debt repayment, share buybacks, and acquisitions.

So, what are investors supposed to do when companies knowingly overstate their financial health?

This isn’t new. It happens all the time in both public and private markets. Management teams, founders, and investment bankers are all incentivized to present the highest revenue and earnings figures possible. Meanwhile, investors, lenders, and acquirers are left to figure out whether the numbers are inflated and where the real risks lie.

How did we get here?

The use of some of these financial tricks dates back to the 1990s with the rise of Non-GAAP financials. Initially, they were helpful as they clarified non-cash or one-time impacts of certain accounting treatments. But it didn’t take long for companies like Enron and WorldCom to push the boundaries.

Today, the abuse continues. Companies going public still promote terms like "Community-Adjusted EBITDA," made infamous by WeWork. Regulators have taken a hands-off approach, treating these figures as supplemental information rather than misleading data. As a result, management teams have free rein to highlight adjusted numbers in press releases and conference calls, even when they don’t reflect the true financial picture.

EBITDA ≠ Free Cash Flow

EBITDA gained traction thanks to legendary media investor John Malone. He argued that traditional EPS didn’t reflect the true earnings power of his companies and that highlighting EBITDA helped lenders and bankers better understand his ability to repay debt. However, other companies quickly followed suit and started using EBITDA to justify excessive leverage and inflated valuations.

Many investors now like to use EBITDA less capital expenditures as a shortcut for free cash flow, but that is flawed, too. What kind of capex are we talking about? Historical, maintenance, or growth capex? In asset-light industries like staffing or construction, working capital needs are high while capex is low, so one of the biggest costs for a company isn’t highlighted in the FCF picture. In capital-intensive industries, EBITDA can make a business look more valuable than it really is because current depreciation masks the true cost of maintaining and buying new equipment.

The Stock-Based Compensation Problem

Perhaps the most egregious adjustment to free cash flow is stock-based compensation (SBC). Tech companies are the worst offenders, where SBC can account for 30% or more of revenues. As Warren Buffett put it: "The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?"

SBC is treated as a non-cash expense on the statement of cash flows, but make no mistake, it’s a real cost to shareholders. If a company issues shares worth 2% or more of its value each year, that dilutes the ownership stake of existing shareholders.

The Bottom Line

You can slice and adjust a company’s earnings in countless ways. Lenders, analysts, investment bankers, value investors, growth investors, and management teams will all see the numbers differently. It’s your job to cut through the noise and figure out what the real free cash flow is because, in the world of corporate finance, the headline number rarely tells the whole story.