As stated in our Return on Capital example, the Jack Co earned $5000 in free cash flow last year. That is to say, the company earned $5000 in cash that it can pay to its shareholders.

Dividends:

The company might decide, for instance, to pay a dividend. This means that the Jack Co would pay the $5000 in cash to its shareholders.

Share Repurchases:

Or, the company could also do something known as a "share repurchase."

The Jack Co, our imaginary company, has has 1000 shares of stock outstanding. Someone who owns all 1000 shares would own the whole company. I own ten percent of the shares (which is 100 shares); thus I own ten percent of the company.

If you divide the total net income of the Jack Company, which is now $11,000, by the number of shares, which is 1000, you get an earnings per share of $11.

The Jack Company, after building its two lemonade stands, has decided to stop growing. They will not build any lemonade stands this year; thus, the company will not grow, and its free cash flow will be equal to its net income of $11,000. The company has decided to use that money to buy its own stock.

With The Jack Co trading at $100 per share, The Jack Company's $11,000 buys 110 shares ($11,000 / $100 = 110). The company eliminates these shares; thus, they no longer exist. Now, there are only 890 shares left (1000 - 110 = 890).

I still own 100 shares, but my 100 shares are now more than ten percent of the company. They are, in fact, 100/890 or 11.24 percent of the company. In fact, with onlu $890 shares outstanding, the Jack Co's earnings per share is now ($11,000/890), which is $12.36. Just by repurchasing shares, the earnings per share of the company grew. And this growth will eventually cause the stock's share price to increase.

Acquisitions:

A company can also use its cash to acquire another company. For example, suppose Joe owns a chain of 4 lemondade stands that provide $1,000 in annual income. Joe says to Jack, "I'll sell you my business for $10,000." Jack notices that he earned $10,000 in cash last year and decides to use it to purchase Joe's company.

So, if Jack's company earns $10,000 per year, while Joe's earns $1,000 per year, if the companies combine, the new company will earn $11,000 per year. Thus, by acquiring Joe's business, the Jack company is able to increase its income by $1,000 per year.