Free Cash Flow Valuation

Welcome to Free Cash Flow Valuation!

In your CFA Level I journey, you likely encountered the Dividend Discount Model (DDM). But what happens when a company doesn’t pay dividends? Or what if a company pays out far less than it can actually afford? That is where Free Cash Flow (FCF) valuation saves the day!

In this chapter, we are going to learn how to value a firm by looking at the actual cash it generates, rather than just the dividends it sends to shareholders. Think of FCF as the "take-home pay" of a business after it has paid its bills and reinvested in itself to stay competitive. Don't worry if the formulas look a bit long at first—we will break them down piece by piece until they feel like second nature.

1. FCFF vs. FCFE: Who gets the cash?

Before we dive into the math, we need to distinguish between the two main types of Free Cash Flow. The primary difference is who has a claim on that money.

Free Cash Flow to the Firm (FCFF)

This is the cash flow available to all of the company’s capital providers. This includes common stockholders, preferred stockholders, and bondholders (debt holders). Since it belongs to everyone, we use the Weighted Average Cost of Capital (WACC) to discount these flows.

Free Cash Flow to Equity (FCFE)

This is the cash flow left over specifically for the common shareholders. It is what’s left after the company has paid its operating expenses, reinvested in fixed assets, and—crucially—paid off its interest and principal to debt holders. Since this belongs only to shareholders, we discount it using the Required Return on Equity (\(r\)).

Quick Analogy: Imagine a lemonade stand. FCFF is the total cash in the jar after buying lemons and sugar. FCFE is what’s left in the jar after you also pay back the \$5 you borrowed from your mom to buy the pitcher!

Key Takeaway:

Use FCFF when you want to value the entire business. Use FCFE when you want to value just the stock. Always match the cash flow to the correct discount rate: FCFF with WACC, and FCFE with Cost of Equity.

2. Calculating FCFF: Starting from the Top

The exam will often ask you to calculate FCFF starting from different points on the financial statements. Don’t panic—the logic is always the same: Add back non-cash stuff, add back interest (since FCFF is for debt holders too), and subtract investments.

Starting from Net Income (NI)

\( FCFF = NI + NCC + [Int \times (1 - Tax Rate)] - FCInv - WCInv \)

Breaking it down:
1. NI (Net Income): Our starting point.
2. NCC (Non-Cash Charges): We add back things like Depreciation and Amortization because no actual cash left the building.
3. Int(1 - Tax): We add back interest because FCFF belongs to bondholders too! We multiply by (1 - Tax) because interest provides a tax shield that the firm wouldn't have if it didn't have debt.
4. FCInv (Fixed Capital Investment): Subtract cash spent on equipment/buildings (CapEx). Tip: \(FCInv = \text{Ending Gross PP\&E} - \text{Beginning Gross PP\&E}\).
5. WCInv (Working Capital Investment): Subtract the cash tied up in day-to-day operations (like inventory and accounts receivable). Note: Do NOT include cash or short-term debt here.

Starting from EBIT or EBITDA

If the exam gives you EBIT, you've already "ignored" interest, but you still need to account for taxes:
\( FCFF = [EBIT \times (1 - Tax Rate)] + Dep - FCInv - WCInv \)

If you start with EBITDA, remember that Depreciation hasn't been subtracted yet, so you get a tax break on it:
\( FCFF = [EBITDA \times (1 - Tax Rate)] + (Dep \times Tax Rate) - FCInv - WCInv \)

Key Takeaway:

When calculating FCFF, always "fix" the interest. Since interest was subtracted to get to Net Income, we must add it back (tax-adjusted) to see the total cash available to everyone.

3. Calculating FCFE: The Shareholders' Share

If you already have FCFF, finding FCFE is easy! You just take out what the debt holders get and add what you borrowed.

The Formula:
\( FCFE = FCFF - [Int \times (1 - Tax Rate)] + \text{Net Borrowing} \)

What is Net Borrowing?
It is (New Debt Issued - Principal Repaid). If the company took out more loans than it paid back, it has more cash to give to shareholders!

Common Mistake Alert: Students often forget that an increase in Working Capital (like more Inventory) is a use of cash, so it should be subtracted. If Working Capital decreases, it’s a source of cash, so you add it!

Key Takeaway:

FCFE is essentially FCFF minus the obligations to creditors plus the cash gained from new debt. It represents the "true" dividend-paying capacity of the firm.

4. Forecasting Free Cash Flow

To value a company, we need to project these cash flows into the future. There are two main ways the curriculum approaches this:

The Constant Growth Model (Single Stage)

This is just like the Gordon Growth Model but using FCF instead of Dividends.
\( \text{Value of Firm} = \frac{FCFF_1}{WACC - g} \)
\( \text{Value of Equity} = \frac{FCFE_1}{r - g} \)

The Two-Stage Model

Real companies often grow fast for a few years and then settle down. To value these:
1. Calculate the FCF for each "high growth" year and discount them to today.
2. Calculate the Terminal Value at the end of the high growth period using the constant growth formula.
3. Discount that Terminal Value back to today and add it to your other discounted cash flows.

Did you know? The terminal value often accounts for 75% or more of the total value in a DCF model. This is why getting your "long-term growth rate" (g) right is so important!

5. Why use FCF instead of Dividends?

You might be wondering, "Why do all this extra work if I can just use DDM?" Here is when FCF is the better choice:

• The company does not pay dividends.
• The company pays dividends, but they are significantly different from the company's capacity to pay (e.g., they are hoarding cash).
• You are taking a control perspective. If you were buying the whole company, you could change the dividend policy, so you care about the total Free Cash Flow you'd control.
• FCFE is especially useful for companies with unstable dividend histories but stable cash flow patterns.

Summary Checklist for Success:

1. Check your starting point: Are you starting from NI, EBIT, or CFO?
2. Adjust for Non-Cash: Always add back Depreciation.
3. Mind the Taxes: Remember that Interest is tax-deductible when adding it back for FCFF.
4. Match the Rate: FCFF goes with WACC; FCFE goes with \(r\) (Cost of Equity).
5. Net Borrowing: Only include this when calculating FCFE, never FCFF.

Keep practicing these formulas! At first, they feel like a lot of moving parts, but once you see the logic—that we are simply adjusting accounting "profits" into actual "cash"—it all starts to click. You've got this!