Valuation and the use of free cash flows

Welcome to Valuation and Free Cash Flows!

Welcome, future financial managers! In the world of Advanced Financial Management (AFM), one of the most critical skills you will learn is how to determine what a business is actually worth. While accounting profits are important, they can be misleading. In this chapter, we focus on Free Cash Flows (FCF)—the actual "cold, hard cash" that a business generates.

Don't worry if this seems tricky at first. Think of a business like a personal bank account: it's not about how much you "earned" on paper; it's about how much cash is left in your pocket after paying your bills and putting some aside for future needs. Let's dive in!

1. What Exactly is Free Cash Flow (FCF)?

In simple terms, Free Cash Flow is the cash that a company has left over after it has paid for all its operating costs and invested in the equipment and assets it needs to keep running.

In AFM, we distinguish between two main types of FCF:

A. Free Cash Flow to the Firm (FCFF): This is the cash available to everyone who has provided money to the business—both the bank (debt holders) and the owners (equity holders).
B. Free Cash Flow to Equity (FCFE): This is the cash available only to the shareholders after the bank has been paid its interest and any debt has been repaid.

Quick Review: The "Pizza" Analogy

Imagine the company's total cash is a large pizza. FCFF is the whole pizza before anyone starts eating. FCFE is the portion of the pizza left for the shareholders after the bank has taken its slices (interest and debt repayments).

2. Calculating Free Cash Flow to the Firm (FCFF)

To find the value of a business, we usually start with FCFF. Here is the step-by-step process to calculate it from accounting figures:

1. Start with Operating Profit (PBIT).
2. Subtract Tax (usually calculated as \(PBIT \times \text{tax rate}\)).
3. Add back Depreciation and Non-cash charges (because no cash actually left the building).
4. Subtract Capital Expenditure (CapEx) (cash spent on buying new machines or buildings).
5. Subtract (or add) Changes in Working Capital (cash tied up in inventory or owed by customers).

The Formula:

\(FCFF = \text{Operating Profit (1 - t)} + \text{Depreciation} - \text{Capital Expenditure} - \text{Increase in Working Capital}\)

Did you know? Many students forget that an increase in Working Capital is a cash outflow. If your customers owe you more money this year than last year, that’s cash you don't have in your hand yet!

3. Using FCF to Value the Business

Once we have the FCF, we can use it to find the Enterprise Value (EV) of the firm. The Enterprise Value is the total value of the company’s core business operations.

Step-by-Step Valuation Process:

Step 1: Forecast the FCF for a specific period (usually 3 to 5 years).
Step 2: Calculate the "Terminal Value." Since we can't forecast forever, we assume the business grows at a steady, constant rate after the forecast period.
Step 3: Discount everything back to today using the Weighted Average Cost of Capital (WACC).

The Terminal Value Formula:

To find the value of all cash flows from a certain point into infinity, we use the Gordon Growth Model:
\(PV = \frac{FCF_1}{r - g}\)
Where:
- \(FCF_1\) = The cash flow in the first year of the growth period.
- \(r\) = The discount rate (WACC).
- \(g\) = The constant growth rate.

Important Note: Always ensure the growth rate (\(g\)) is lower than the discount rate (\(r\)). If it’s higher, the math breaks, and the business would eventually become larger than the entire world economy!

4. Matching the Rate to the Flow

This is where many students lose easy marks. You must match the correct discount rate with the correct cash flow:

- Use WACC when discounting Free Cash Flow to the Firm (FCFF). This gives you the Enterprise Value.
- Use Cost of Equity (\(K_e\)) when discounting Free Cash Flow to Equity (FCFE). This gives you the Equity Value directly.

Memory Aid: "Firm = Full"

The Firm value is the "Full" value (Debt + Equity), so you use the "Full" cost of capital (WACC).

5. From Enterprise Value to Share Price

If you have used FCFF and WACC, you have calculated the Enterprise Value. To find the value belonging to the shareholders (Equity Value), you must subtract the debt:

Equity Value = Enterprise Value - Value of Debt + Cash/Non-operating assets

To find the Value Per Share:
\(\text{Value Per Share} = \frac{\text{Equity Value}}{\text{Number of Shares}}\)

6. Common Pitfalls to Avoid

1. Timing Errors: Be careful with "Year 1" vs "Year 0." If the first FCF occurs in one year's time, it is a Year 1 flow. If a growth rate is applied "immediately," check the wording carefully to see if the first growth-adjusted flow starts in Year 1 or Year 2.

2. Ignoring Inflation: In the AFM exam, if cash flows are given in "real" terms, you must either use a "real" discount rate or inflate the cash flows and use a "nominal" rate. Usually, it is easier to inflate the cash flows.

3. Overstating Growth: Be realistic. If the question doesn't give a growth rate, you might need to calculate it using the Retained Earnings (Gordon's) method: \(g = b \times r\), where \(b\) is the retention ratio and \(r\) is the return on capital.

Summary Takeaways

Key Terms:
- FCFF: Cash for everyone; discount using WACC.
- FCFE: Cash for shareholders; discount using \(K_e\).
- Terminal Value: The value of the business beyond the forecast period.
- Enterprise Value: The total value of the business (Debt + Equity).

The Golden Rule: Valuation is about the future. We use historical data only to help us predict what will happen next. Always check if your final answer makes "common sense"—is the share price you calculated wildly different from the current market price? If so, think about why!

Keep practicing! Valuation is a core pillar of the AFM syllabus. Once you master the link between cash flows and discount rates, you've conquered one of the biggest hurdles in the exam.