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
• The investor takes a control perspective
The FCFF approach computes the value of the firm by discounting the free cash flow to the firm at the Weighted Average Cost of Capital (WACC) of the firm and then deducting the value of non-common stock capital (usually debt and preferred stock) to arrive at the value of equity.
The FCFE approach on the other hand can be used to directly find out the fair value of the equity of the firm by valuing free cash flows available to equity shareholders discounted at cost of capital.
Free cash flow to firm is the cash available to bond holders and stock holders after all expenses and investments have taken place. It’s one of the many benchmarks used to compare and analyse financial health and in the valuation exercise. A positive value would indicate that the firm has cash left after expenses. A negative value, on the other hand, would indicate that the firm has not generated enough revenue to cover its costs and investment activities. In that instance, an investor should dig deeper to assess why this is happening – it could be a sign that the company may have some deeper problems.
FCFE is the cash available to stock holders after all expense, investments and interest payments to debt-holders on an after tax basis.
FCFF = NI + NCC + 1 ( 1 – T ) – FC – WC
NCC= non-cash charges such as depreciation and amortization
NI = Net income. I (1-t) = After-tax interest expense.
FC = Change in fixed capital investments.
WC = Change in working capital investments.
CFO = cash flow from operations
Net income is post the interest paid to the company’s bondholders, but the definition of FCFF is the cash available to the firm’s bondholders and equity holders. So it is the money before paying the interest, thus, we need to add back the after tax expense of interest.
FCFF = EBIT( 1 – T ) + NCC – FC – WC
FCFF is on an after tax basis and EBIT is before taxes, so we need to multiply by the firm’s after tax rate which is (1-T). EBIT is pre interest charges, so we do not need to add back I (1-T).
FCFF = ( 1- T ) + CFO – FC
CFO adds back depreciation and takes account of change in WC, so the only thing left that is not accounted for is the interest expense and change in Fixed Capital Investments.
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) debt holders.
FCFE = FCFF + Net Borrowing – 1( 1-T)
We need to subtract the interest expense now because FCFE is all the cash available to stock holders.
FCFE = NI + NCC – FC -WC + Net Borrowing
This formula again doesn’t include the addition of I (1-T) back because NI already deducted it out.
FCFE = CFO + Net Borrowing – FC
Notice FCFF adds back I (1-T) but FCFE doesn’t. The value of equity can be found by discounting FCFE at the required rate of return on equity r:
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.
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.
FCFE in any period will be equal to FCFE in the preceding period times (1 + g):
FCFEt = FCFEt – 1 * (1 + g)
If we assume that at some time in the future the company will grow at a constant growth rate g forever, then using Gordon Growth Model, we get the terminal value as
The value of equity if FCFE is growing at a constant rate g is
TV = (FCFEt) / (Ke – g)
The discount rate is Ke, the required return on equity. The growth rate of FCFF and the growth rate of FCFE are frequently not equivalent.
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. 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.
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 percentage of assets. In this case, FCFE can be written as
FCFE = NI – (1-DR) * (Capital Spending – Depreciation)
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.
When we are calculating FCFE starting with Net income available to common shareholders, 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.
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.
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.
Finally, we value XYZ using the FCFE method of valuation. Please note that FCFF and FCFE both will yield the same intrinsic value of XYZ equity as the company does not have any debt on its balance sheet.
Step 1—
Forecast Expected Cash Flow: the first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company’s revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement. We describe these variables and how to estimate them in other screens.
Step 2—
Estimate the Discount Rate: the next order of business is to estimate the company’s weighted average cost of capital (WACC), which is the discount rate that’s used in the valuation process. We describe how to do this using easily observable inputs in other screens.
Step 3—
Calculate the Value of the Corporation: the company’s WACC is then used to discount the expected cash flows during the Excess Return Period to get the corporation’s Cash Flow from Operations. We also use the WACC to calculate the company’s Residual Value. To that we add the value of Short-Term Assets on hand to get the Corporate Value.
Step 4—
Calculate Intrinsic Stock Value: we then subtract the values of the company’s liabilities—debt, preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock outstanding to get the per share intrinsic stock value.