Free Cash Flow Valuation

1
Free Cash Flow Valuation
2
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).

3
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.

4
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.

5
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.

6
Valuing FCFE

• The value of equity can also 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
  firms equity.
• Dividing the total value of equity by the number
  of outstanding shares gives the value per share.

7
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
• 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.

8
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

9
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

10
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.

11
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.

12
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.

13
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.

14
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.

15
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.