Chapter 4 Free Cash Flow Valuation 147

2.1. Defining Free Cash Flow

Free cash Aow to the firm is rhe cash flow available ro rhe company's suppliers of capiml
after aU operating expenses (i ncluding raxes) have been paid and necessary invesrmenrs in
wodci11g capiral (e.g., invemory) and fixed capir.al (e.g., equipmenr) have been made. FCFF
is the cash flow from operations minus capital expendirures. A company's suppliers of capi-
tal include common stockholders, bondholders, and sometimes, preferred stockholders. The
equations analysts use to calculate FCFF depend on rhe accounting information available.
Free cash flow to equity is the cash flow available to the company's holders of common
equity after all operating expenses, interest, and principal payments have been p<1id and neces-
sary investments in worlcing and 6xed capital have been made. FCFE is the cash Aow from
operations minus capital expenditures minus payments to (and plus receipts from) debt holders.
T he way in which free cash flow is related to a company's net income, cash flow from
operations, and m.:asures such as EBITDA (earnings before taxes, depreciation, and
amortizatio n) is i mpo rranr: The analyst musl! undc::rstand the relatio nship between a com-
pany's reported accounti ng data and free cash Aow i n o rder co forecast free cash flow and
irs expected growth. Although a company reports cash flow from operarions (CFO) on the
statement of cash flows, CFO is not free cash flow. Net income and CFO data can be used,
however, in determining a c.ompany's free ca.sh Aow.
The adva nrage of FCFF and FCFE over other cash flow conceprs is that they can be
used direcrly in a DCF framework to value the fi rm or to value equity. Other cash Aow- or
earnings-related measures, such as CFO, net income, EBIT, and EBITOA, do not have rhis
property because they eirher double-counr or omir cash Rows in some way. For example,
EBIT and EBITDA are before- tax measu1es, and rhe cash flows avai b ble to inveswrs (i n
the 6rm or in the equity of the firm) musr be after tax. From the srockholders' perspecdve,
EBITDA and similar measures do not accouoc for differing capital Stl'uctures (the after-tax
interest expenses or preferred dividends) or for the funds that bondholders supply to finance
invesrmerns in assets. Moreover. chese n"'easures do nor account for the rei nvest-
ment of cash llows that the company makes in capital assets and working capit"OI to main min
or maximize the long-run value of the fi rm.
Using free cash Aow in valuation is more challenging than using dividends because
in forecasting free cash flow, the analyst must integrate the cash flows from the company's
operations with those from its investing and fi nancing activities. FCFF is the after-
tax cash Row going to all suppliers of capital to the fi rm, the value of the fi rm is estimated
by discounting FCFF at the weighted average cost of capital (WACC). An estimate of the
value of equity is then found by subtracting the value of debt from the esti mated value of
the fi rm. T he value of equity can also be estimated directly by discounting FCFE at the
required rare of return for equity (because FCFE is rhe cash Aow goi ng ro common srock-
holders, the required ra te of return on equity is the appropriate risk-adjusrcd rare for dis-
counti ng FCFE).
The IWO free cash Aow approaches, indi rect and direcr, for valuing equity should rheo-
rerically yield rhe same esrimares if all inputs reRect identical assurn prio ns. An analysr may
prefer ro use o ne approach rarher rhan rhe Olhert howevert because of the characrerisrics of
the company being valued. E'or example, if rhe company's capital srructure is ,elatively smble,
using FCFE to value equity is more direcr and simpler than using FCFF. The FCFF model is
often chosen, however, in rwo ocher cases:
I. A comparty with ntgarive FCFE. In this case, working with FCFF to va lue the
compan.y's equiry might be easiest. T he analyst would discount FCFF to find the present
Chapter 4 Free Cash Flow Valuation 151
3. FORECASTING FREE CASH FLOW
EsrLmaring FCFF or FCFE requires a complere understandi ng of the company and irs finan-
cial sroremenrs. To provide a comexr lor rhe estimation of FCFF and FCFE, we lirsr use an
extensive example co show the relationship between free cash Aow and accounrhtg measures
of income.
For mosr of chis section, we assume rhat the company has rwo sources of capital, debt
and common stock. Once the concepts of FCFF and FCFE are understood for a comp;\n)'
financed by using only debr and common sro.ck, ir is easy to incorpomte preferred srock for
the relatively small number of companies that acrually use it (in Section 3.8 we incorporate
preferred srock as a third source of capital) .
3.1. Computing FCFF from Net Income
FCFF is the cash Bow avai lable ro rhe company's suppliers of capiral after all opemting
expenses (includi ng taxes) have been paid and operaring investments have been made. The
company's suppliers of capiral include bondltolders and common shareholders (plus, occ\-
sionally, holders of preferred stock, which we ignore unti l later). Keeping in mind that a non-
cash charge is a charge or expense rhat does nor involve the outlay of cash, we em write the
expression for FCFF as follows:
FCFF = Net income available co common shareholders (Nl)
Plus: Ner noncash charges (NCC)
Plus: Interest expense X (1 -Tax rare)
Less: lnvesunem in fixed capiml
4
(FCinv)
Less: lnvestmcnr in worki ng capital (W'Clnv)
This equarion can be written more compacrly as
FCFF = Nl + NCC + lnt(l -Tax rare}- FClnv- WClnv (4-7)
Consider each component of FCFE The starring poinr in Equarion 4-7 is net income
available ro comrnon shareholders-the borrom line in an income sraremenr. [r represents
income after dep1eci:nion, amortization, interesr expense, inoome raxes, and the paymenr of
dividends ro preferred shareholders (bur nor paymenr of dividends ro common
Ner noncash charges represenr an adjusnnenr for noncash decreases and increases in ner
income. T his adjustment is the first of se''etal thar analysts genemlly perform on a net basis. If
noncash decreases in ner income exceed the increases, as is usually dte case, the adjusunent is
positive. If noncash increases exceed noncash decreases, rhe adjustment is negative. The most
common noncash charge is depreciation expense. When a company purchases fixed C\piml,
such as equipment, the balance sheer reflects a cash outflow at the time of the purchase. In sub-
sequent periods, the company records depreciation expense as the asset is used. The depreciation
expense reduces nee income but is not a cash oudlow. Depreciation expense is thus one (the
mosr common) noncash charge that must be added back in computing FCFF. ln the case of
4
In rhls chapter. when we refer to investment in capim.l" or "'investment in working c::apiraJ,"'
we arc referring to tht invcstmc:nu made in che: sp(;cific ptriod for which rhc fru cash Aow is being
c:tlculared.
152 Equity Asset Valuation
intangible assets, there is a similar noncash charge, amoni1;1rion which must be added
back. Other noncash charges vary from company to company and are discussed in Section 3.3.
Afrer-rax interest expense mu.<r be added back to net income ro arrive ar FCFF. This srep
is required because inrerest expense net of dle relared tax savjngs was deducted in arriving :u
net income and bec>use imeresr is" cash flow available to one of rhe company's C.'lpiral pro-
viders (i.e., rhe company's creditors). In rhe United Srares and many other counrries. inreresr
is rax deductible (reduces raxes) for rhe company (borrower) and raxable for rhe recipient
(lender). As we explain larer, when we discouor FCFF, we use an afrer-rax cost of capital. For
consistency, we rhus com pure FCFF by using the afrer-rax interest paid.
1
Similar ro afrer-rax interest expe11se, if a company has preferred stock, dividends on rhar
preferred stock are deducted in arriving >t net income >vailable ro common shareholders.
Because preferred stock dividends are also a cash flow available to one of the company's capi-
tal providers, this item is added back to arrive at FCFF. Further discussion of the effects of
preferred stock is in Section 3.8.
Investments in fixed capital represent the ourAows of cash to purchase fixed capital
necessary to suppon the company's current and future operations. These investments arc cap-
ital expenditures for long-term assets, such as the property, plant, and equipment (PP&E)
necessary to support the company's operations. Necessary capital expenditures may also
include intangible a.sscts) such as trademarks. In the case of cash acquisition of another conl -
pany instead of a direct acquisitio n of PP&.E. the cash purchase amount can also be treated
as a capital expenditure that reduces the company's free cash Aow (note that this treatment
is conservarive because ir reduces FCFF). In t he case of htrge acquisitions (a nd all noncash
acquisitions), analysts must rake c:1re ill evaluating rhe impacr on furure free cash Aow. If a
company receives cash in disposing of any of irs fixed capiral, rhe analyst musr deduct chis
cash in calculating invesrmenr in fixed capiraL For example, suppose we had a sale of equip
mem for $100,000. This cash inflow would reduce the company's cash ourflows for invest-
ments in fixed capital.
The company's cash flow statement is an excellent source of information on capital
expenditures as well as on sales of fixed capiral. Analysts should be aware char some compa-
nies acquire fixed capital without using cash-for example, through an exchange for stock
or debt. Such acquisitions do nor appear in a company's cash flow statement bur, if mare-
rial, must be disclosed in rhe footnotes. Although noncash exchanges do nor affect historical
FCFF, if the capital expenditures are necessary and may be made in in the future, the
analyst should usc this information in forecasting future FCFF.
The final po int to cover is the impo rtant adjustment for ncr inc rease.s in working capital.
T his adjustment represents the net invcstmenr in current assets (such as accounts receivable)
less current liabilities (such as accounts payable:). Analysts can fi nd this information by exam-
ining either the compan)/s balance sheet or its cash Row statement.
Although working capital is often ddincd as current assets minus current liabilities)
working capital for cash Aow and valuation purposes is defined to exclude cash and short
term debt (which includes notes payable and rhe current portion of long-term debt). When
finding rhe net increase in working capital for the purpose of calculating free cash Aow, we
define working capiral to exclude cash and c.sh equivalentS as well as notes payable and rhe
currenr porrion of long rernt debt. Cash and cash equivalems are excluded because a change
that we could compute \Y/ACC on a pretax; basis and compute FCFF by adding back interest
paid with no rax adjusrmenr. Whichever approach i s adoptcd, tht analyst musr usc mutually consistent
definitions of FCFF and WACC.
Chapter 4 Free Cash Flow Valuation 155
3.2. Computing FCFF from the Statement of Cash Flows
FCFF is cash Aow avai lable ro all providers of capital (debe and equiry). AJ>alysrs frequently
use cash fl ow from operarions, raken from rhe sraremenr of cash Bows, as a siarti ng poi nr ro
compute free c.lsh Bow bec.1use CFO incorporares adjusunenrs for noncash expenses (such as
depreciarion and amorrizarion) as well as for ner investments in worki ng capital.
In a smremenr of cash Aows, cash Aows are sepanued inro rhree components: cash Aow from
operating acrivities (or c.1sh flow from operations), cash Aow from investing activities, and c.1sh
flow from financing activiries. C.1Sh flow from operations is rhe ner amount of cash provided by
the company's operating acrivicies. T he operatin.g section of the cash Row sratemenr shows such
cash flows as cash received from customers and cash paid to suppliers. Cash flow &om investing
activiti<:S includes rhe company$ investments in (or sales of) long-tenn assets-for example, PP&E
and long- term investments in other companies. Cash Row from financing activities relates to rhe
company's activities in raising or repaying capital. International Financial Reporting Standards
(IFRS) allow rhc company to inreresr paid as either an operaring or financi ng acrivity.
Furrhermore, I FRS allow dividends paid robe classified as eirher an opemring or financing acrivity.
lnrerestingly, under U.S. generally acceprcd accounting principles (GAAP}, inreresr expense paid
ro providers of debr capiral musr be classified as parr of cash Aow fTom operarions (as is inreresr
income} bur paymcnr of dividends ro providers o f equil) capiral is classifi ed as a financing acrivi ry.
Exhibir 4-4 summarizes I FRS and U.S. GAAP rrcarmenr of inreresr and dividends.
EXHIBIT 4-4 !FRS versus U.S. GAAP Trearmenr of lnr<resr and Dividends
I FRS U.S. GMP
Interest received Operating or Investing Operating
l nrcresr paid Operating or Financing Operati ng
Dividends received Operating or lnvescing Opera ring
Dividends paid Opc:r.ting Olf Fimmcing
To esrimare FCFF by stal'fing wi rh CFO, we musr 1ecognize rhe rrearmenr of inreresr paid.
If rhe afrer-c'lX interest expense was taken our of ner income and ourofCFO, as wirh U.S. GAAP.
rhen afrer-rax inreresr expense musr be added back to ger FCFF. In rhe case of U.S. GAAP, FCFF
can be esdmared as follows:
or
Free cash Aow ro rhe firm = Cash flow from operations
Plus: l nreresr expense X (I -Tax rare}
Less: lnvesrment in fixed capiral
FCFF = CFO + lnt{l -Tax ra te) - FC!nv (4-8)
To rei terate, the after-taX interest expense is added back because it was previously taken
out of net income. The invesrment in worki ng capital does not appear in Equ:uion 4-8
because CFO already includes invesrment in working capital. Example 4-3 illustrates the use
of CFO to calculate FCFF. In rhis example, the calculation of CFO begins with calculating
nc:t income, an approach known as the method.
6
6
Sce Robinson, van Gr<:uning, Henry, and Broihahn (2009b) for a discu>Sion of the indirect and di rect
cash Aow statc::mc:nt formats.