Free Cash Flow

Valuation
 Intro to Free Cash Flows
Dividends are the cash flows actually paid to
stockholders
Free cash flows are the cash flows available
for distribution.
Applied to dividends, the DCF model is the
discounted dividend approach or dividend
discount model (DDM). This chapter extends
DCF analysis to value a firm and the firm’s
equity securities by valuing its free cash flow
to the firm (FCFF) and free cash flow to
equity (FCFE).
Intro to Free Cash Flows
Analysts like to use free cash flow valuation
models (FCFF or FCFE) whenever one or
more of the following conditions are present:
• the firm is not dividend paying,
• the firm is dividend paying but dividends
differ significantly from the firm’s capacity to
pay dividends,
• free cash flows align with profitability within
a reasonable forecast period with which the
analyst is comfortable, or
• the investor takes a control perspective.
Intro to Free Cash Flows
Common equity can be valued by either
• directly using FCFE or
• indirectly by first computing the value of
the firm using a FCFF model and
subtracting the value of non-common
stock capital (usually debt and preferred
stock) to arrive at the value of equity.
Defining Free Cash Flow
Free cash flow to equity (FCFE) is the
cash flow available to the firm’s common
equity holders after all operating expenses,
interest and principal payments have been
paid, and necessary investments in
working and fixed capital have been made.
• FCFE is the cash flow from operations minus
capital expenditures minus payments to (and
plus receipts from) debtholders.
Valuing FCFE
 The value of equity can also be found by
discounting FCFE at the required rate of return on
equity (r):



FCFEt
Equity Value 
t 1 (1  r )t
 Since FCFE is the cash flow remaining for equity
holders after all other claims have been satisfied,
discounting FCFE by r (the required rate of return
on equity) gives the value of the firm’s equity.
 Dividing the total value of equity by the number of
outstanding shares gives the value per share.
 Single-stage, constant-growth
FCFE valuation model
FCFE in any period will be equal to FCFE in the
preceding period times (1 + g):
• FCFEt = FCFEt–1 (1 + g).
The value of equity if FCFE is growing at a
constant rate is
FCFE1 FCFE0 (1  g )
Equity Value  
rg rg
The discount rate is r, the required return on
equity. The growth rate of FCFF and the growth
rate of FCFE are frequently not equivalent.
Computing FCFF from Net Income

This equation can be written more compactly

as
FCFF = NI + Depreciation + Int(1 – Tax rate) – Inv(FC) –
Inv(WC)

 Or
 FCFF = EBIT(1-tax rate) + depreciation – Cap. Expend. – change in
working capital – change in other assets
Finding FCFE from NI or CFO
Subtracting after-tax interest and adding
back net borrowing from the FCFF
equations gives us the FCFE from NI or
CFO:
FCFE = NI + NCC – Inv(FC) – Inv(WC)
+ Net borrowing
FCFE = CFO – Inv(FC) + Net borrowing
Forecasting free cash flows
 Computing FCFF and FCFE based upon
historical accounting data is straightforward.
Often times, this data is then used directly in a
single-stage DCF valuation model.
 On other occasions, the analyst desires to
forecast future FCFF or FCFE directly. In this
case, the analyst must forecast the individual
components of free cash flow. This section
extends our previous presentation on computing
FCFF and FCFE to the more complex task of
forecasting FCFF and FCFE. We present FCFF
and FCFE valuation models in the next section.
Forecasting free cash flows
 Given that we have a variety of ways in which to
derive free cash flow on a historical basis, it
should come as no surprise that there are
several methods of forecasting free cash flow.
 One approach is to compute historical free cash
flow and apply some constant growth rate. This
approach would be appropriate if free cash flow
for the firm tended to grow at a constant rate
and if historical relationships between free cash
flow and fundamental factors were expected to
be maintained.
Forecasting FCFE
 If the firm finances a fixed percentage of its capital
spending and investments in working capital with
debt, the calculation of FCFE is simplified. Let DR
be the debt ratio, debt as a percentage of assets. In
this case, FCFE can be written as
 FCFE = NI – (1 – DR)(Capital Spending – Depreciation)
– (1 – DR)Inv(WC)
 When building FCFE valuation models, the logic,
that debt financing is used to finance a constant
fraction of investments, is very useful. This
equation is pretty common.
 Preferred stock in the capital
structure
 When we are calculating FCFE starting with Net income
available to common, if Preferred dividends were already
subtracted when arriving at Net income available to
common, no further adjustment for Preferred dividends is
required. However, issuing (redeeming) preferred stock
increases (decreases) the cash flow available to
common stockholders, so this term would be added in.
 In many respects, the existence of preferred stock in the
capital structure has many of the same effects as the
existence of debt, except that preferred stock dividends
paid are not tax deductible unlike interest payments on
debt.
Nonoperating assets and firm value
 When calculating FCFF or FCFE, investments in working
capital do not include any investments in cash and
marketable securities. The value of cash and marketable
securities should be added to the value of the firm’s
operating assets to find the total firm value.
 Some companies have substantial non-current
investments in stocks and bonds that are not operating
subsidiaries but financial investments. These should be
reflected at their current market value. Based on
accounting conventions, those securities reported at
book values should be revalued to market values.
Nonoperating assets and firm value

Finally, many corporations have

overfunded or underfunded pension plans.
The excess pension fund assets should be
added to the value of the firm’s operating
assets. Likewise, an underfunded pension
plan should result in an appropriate
subtraction from the value of operating
assets.