FCF Computation
What you'll learn
- LOS 19.aCompare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation.
- LOS 19.bExplain the ownership perspective implicit in the FCFE approach.
Forget about all the complicated financial statement relationships for a minute and simply picture the firm as a cash processor. Cash flows into the firm in the form of revenue as it sells its product, and cash flows out as it pays its cash operating expenses (e.g., salaries and taxes, but not interest expense, which is a financing and not an operating expense). The firm takes the cash that’s left over and makes short term net investments in working capital (e.g., inventory and receivables) and long term investments in property, plant, and equipment (PP&E).
The cash that remains is available to pay out to the firm’s investors: bondholders and common shareholders (let’s assume for the moment that the firm has not issued preferred stock). That pile of remaining cash is called free cash flow to the firm (FCFF) because it’s free to pay out to the firm’s investors (see Figure 19.1). The formal definition of FCFF is the cash available to all of the firm’s investors, including stockholders and bondholders, after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short and long term investments.
What does the firm do with its FCFF? First, it takes care of its bondholders because common shareholders are paid after all creditors. So it makes interest payments to bondholders and borrows more money from them or pays some of it back.
However, making interest payments to bondholders has one advantage for common shareholders: it reduces the tax bill.
The amount that’s left after the firm has met all its obligations to its other investors is called free cash flow to equity (FCFE), as can be seen in Figure 19.1. However, the board of directors still has discretion over what to do with that money. It could pay it all out in dividends to its common shareholders, but it might decide to only pay out some of it and put the rest in the bank to save for next year. That way, if FCFE is low the next year, it won’t have to cut the dividend payment.
So FCFE is the cash available to common shareholders after funding capital requirements, working capital needs, and debt financing requirements.
Figure 19.1: FCFF and FCFE
We will use the typical discounted cash flow technique for free cash flow valuation, in which we estimate value today by discounting expected future cash flows at the appropriate required return. What makes this complicated is that we’ll end up with two values we want to estimate (firm value and equity value), two cash flow definitions (FCFF and FCFE), and two required returns [weighted average cost of capital (WACC) and required return on equity]. The key to this question on the exam is knowing which cash flows to discount at which rate to estimate which value.
The value of the firm is the present value of the expected future FCFF discounted at the WACC (this is so important we’re going to repeat it as a formula):
The weighted average cost of capital is the required return on the firm’s assets. It’s a weighted average of the required return on common equity and the after tax required return on debt. The formula is presented later in this topic review.
The value of the firm’s equity is the present value of the expected future FCFE discounted at the required return on equity:
Given the value of the firm, we can also calculate equity value by simply subtracting out the market value of the debt:
Details of the calculations are discussed later in this topic review. However, this is an extremely important concept, so memorize it now.
The differences between FCFF and FCFE account for differences in capital structure and consequently reflect the perspectives of different capital suppliers. FCFE is easier and more straightforward to use in cases where the company’s capital structure is not particularly volatile. On the other hand, if a company has negative FCFE and significant debt outstanding, FCFF is generally the best choice.
We can always estimate equity value indirectly by discounting FCFF to find firm value and then subtracting the market value of debt to arrive at equity value.
When a firm’s capital structure is volatile, the adjusted present value (APV) approach can also be used. Under the APV approach, the firm’s unlevered cash flows (i.e., cash flows assuming no impact of leverage) are discounted at the firm’s unlevered cost of equity. NPV of debt (the value of the tax shield, less the cost of financial distress) is then added to the unlevered value.
The ownership perspective in the free cash flow approach is that of an acquirer who can change the firm’s dividend policy, which is a control perspective, or for minority shareholders of a company that is in play (i.e., it is a takeover target with potential bidders). The ownership perspective implicit in the dividend discount approach is that of a minority owner who has no direct control over the firm’s dividend policy. If investors are willing to pay a premium for control of the firm, there may be a difference between the values of the same firm derived using the two models.
Analysts often prefer to use free cash flow rather than dividend based valuation for the following reasons:
- Many firms pay no, or low, cash dividends.
- Dividends are paid at the discretion of the board of directors. It may, consequently, be poorly aligned with the firm’s long run profitability.
- If a company is viewed as an acquisition target, free cash flow is a more appropriate measure because the new owners will have discretion over its distribution (control perspective).
- Free cash flows may be more related to long run profitability of the firm as compared to dividends.