Lesson 7.3: Free Cash Flow Valuation

Introduction

In this lesson, we will dive into the concept of Free Cash Flow (FCF) Valuation, which is a crucial tool in assessing the value of a company. FCF refers to the cash generated by a company after accounting for cash outflows needed to support operations and maintain its capital assets. This lesson covers key objectives that include defining and forecasting free cash flow to the firm and equity, applying single and multistage free cash flow models, computing FCF from financial statements, and understanding the relevant concepts and terminology.

Learning Objectives

1. Define free cash flow to the firm and equity and discuss forecasting techniques.
2. Understand single and multistage free cash flow valuation.
3. Compute free cash flow to the firm and equity from financial statements.
4. Value a firm using multistage free cash flow models.
5. Explain the main ideas and terminology surrounding free cash flow valuation.

What is Free Cash Flow?

Definition

Free Cash Flow (FCF) can be defined as the cash a company generates after taking into consideration the cash outflows that are necessary to maintain or expand its asset base. FCF is essential because it represents the cash that a company can use to distribute to its securities holders, such as debt and equity investors.

Free Cash Flow to the Firm vs. Free Cash Flow to Equity

• Free Cash Flow to the Firm (FCFF): This measures the cash available to all capital providers, including both debt and equity holders. It can be calculated as:

$$\text{FCFF} = \text{EBIT} \times (1 - \text{Tax Rate}) + \text{Depreciation} - \text{Capital Expenditures} - \text{Change in Working Capital}$$

• Free Cash Flow to Equity (FCFE): This represents the cash available to equity shareholders after meeting all expenses and paying off debts. It can be calculated as:

$$\text{FCFE} = \text{Net Income} + \text{Depreciation} - \text{Capital Expenditures} - \text{Change in Working Capital} - \text{Net Debt Repayment}$$

Worked Example 1: Calculating Free Cash Flow to the Firm

Let’s take a hypothetical company, ABC Corp, with the following information:

• EBIT = $500,000

$- Tax Rate = 30%$

• Depreciation = $100,000
• Capital Expenditures = $80,000
• Change in Working Capital = $20,000

1. Calculate FCFF:

$\text{FCFF} = 500,000 \times (1 - 0.3) + 100,000 - 80,000 - 20,000$

$\text{FCFF} = 500,000 \times 0.7 + 100,000 - 80,000 - 20,000$

$\text{FCFF} = 350,000 + 100,000 - 80,000 - 20,000$

$\text{FCFF} = 350,000 + 100,000 - 100,000$

$$\text{FCFF} = 350,000$$

ABC Corp has a Free Cash Flow to the Firm of $350,000.

Forecasting Free Cash Flow

Forecasting Free Cash Flow involves predicting future cash flows based on historical data, expected growth rates, and assumptions about future investments. It's crucial for valuation as investors look for sustainable future cash flows.

Key Steps in Forecasting Free Cash Flow

1. Collect historical financial data: Gather data from the financial statements of the company for several years to identify trends.
2. Estimate revenue growth: Analyze market conditions and the company’s competitive position to project future sales.
3. Project expenses: Estimate future costs while considering fixed and variable expenses.
4. Calculate capital expenditures: Forecast capital requirements based on future operations and growth plans.
5. Estimate working capital needs: Determine the projected need for working capital based on sales growth.

Common Misconceptions

• FCF is purely a measure of profit: While profit is important, FCF measures actual cash availability and reflects a company’s ability to generate cash after necessary expenditures.
• FCF Always Increases with Revenue: Even if revenue increases, FCF can still decline if capital expenditures or working capital requirements increase disproportionately.

Single and Multistage Free Cash Flow Valuation

Single-Stage Free Cash Flow Valuation Model

The single-stage model assumes that free cash flows will grow at a constant rate indefinitely. This model works well for mature companies with stable cash flows.

The present value of FCFF in perpetuity can be calculated as:

$$\text{Value} = \frac{\text{FCFF}}{r - g}$$

Where:

• $r$ = discount rate
• $g$ = growth rate

Worked Example 2: Single-Stage Valuation of a Firm

Using the FCFF calculated from ABC Corp ($350,000), assume a discount rate of 10% and a perpetual growth rate of 5%:

$$\text{Value} = \frac{350,000}{0.10 - 0.05}$$

$$\text{Value} = \frac{350,000}{0.05}$$

$$\text{Value} = 7,000,000$$

Thus, the value of ABC Corp based on a single-stage FCF model is $7,000,000.

Multistage Free Cash Flow Valuation Model

In a multistage model, different growth rates are used for different periods, allowing for varying growth assumptions over time. Typically, a high growth rate is assumed for the initial years, followed by a stable growth rate.

Steps for Multistage Valuation

1. Forecast FCFF for each stage: Predict cash flow for each planned stage with different growth rates.
2. Find terminal value: Calculate the terminal value using the Gordon growth model for the final growth stage.
3. Discount cash flows: Discount the forecasted cash flows and terminal value back to the present value.

Worked Example 3: Multistage Valuation of a Firm

Consider ABC Corp with:

• Initial growth rate of 10% for 5 years
• Terminal growth rate of 4% beyond Year 5

Assuming the FCFF in Year 1 is $350,000, we forecast:

• Year 1: $350,000 \times 1.10 = $385,000
• Year 2: $385,000 \times 1.10 = $423,500
• Year 3: $423,500 \times 1.10 = $465,850
• Year 4: $465,850 \times 1.10 = $512,435
• Year 5: $512,435 \times 1.10 = $563,678.50

Terminal Value Calculation

After Year 5, we apply a terminal growth rate of 4%:

$$\text{Terminal Value} = \frac{\text{Year 5 FCFF} \times (1 + g)}{r - g}$$

$$\text{Terminal Value} = \frac{563,678.50 \times 1.04}{0.10 - 0.04}$$

$$\text{Terminal Value} = \frac{587,810.76}{0.06} = 9,797,179.33$$

Present Value of Cash Flows

Next, we need to discount all cash flows back to the present value:

$$PV = \frac{385,000}{(1 + 0.10)^1} + \frac{423,500}{(1 + 0.10)^2} + \frac{465,850}{(1 + 0.10)^3} + \frac{512,435}{(1 + 0.10)^4} + \frac{563,678.50 + 9,797,179.33}{(1 + 0.10)^5}$$

Calculating each term:

• Year 1 PV: $350,000 / 1.10 = 350,000 / 1.10 = 350,000 * 0.9091 = 318,181.82$
• Year 2 PV: $423,500 / (1.10)^2 = 423,500 0.8264 = 350,000 / 1.21 = 350,000 0.8264 = 350,000 $
• Year 3 PV: $465,850 / (1.10)^3 = 465,800 0.75132 = 350,000 / 1.331 = 350,000 0.7513 = 350,000$
• Year 4 PV: $512,435 / (1.10)^4 = 512,500 0.6830 = 350,000 / 1.4641 = 350,000 0.6830 = 350,000$
• Year 5 PV = 10,360,679.62 / 1.61051 = 10,357,657.58.

Adding these present values together will give you the total value of the firm based on the multistage FCF valuation.

Conclusion

In this lesson, we explored the concept of Free Cash Flow Valuation, distinguishing between Free Cash Flow to the Firm and Free Cash Flow to Equity. We learned how to define, forecast, and calculate these values, as well as how to apply both single and multistage free cash flow valuation models. Understanding the intricacies of free cash flow is vital for investors as it provides insight into a firm's financial well-being and future growth potential.

Study Notes

• Free Cash Flow (FCF) is essential for evaluating a firm's financial health.
• FCFF measures cash available to all capital providers, while FCFE measures cash available to equity investors only.
• Historical financial data is crucial for accurate forecasting of free cash flows.
• Single-stage and multistage models are used for valuing firms based on FCF.
• Keep in mind common misconceptions surrounding FCF and its relationship to profits.