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 firms
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 firms 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 firms 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):

FCFE t
Equity Value
t
(1

r
)
Since FCFE is the cash flow
t 1remaining 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 firms 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 = FCFEt1 (1 + g).

The value of equity if FCFE is growing at a

constant rate is
FCFE1 FCFE 0 (1 g )
Equity Value

rg
rg

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 firms 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 firms operating assets.
Likewise, an underfunded pension plan
should result in an appropriate subtraction
from the value of operating assets.