- Equity Analysis Part 3 - Introduction
- Free Cash Flow Valuation
- One, Two, and Three Stage FCF Calculations
- Share Price Multiple Methods in Equity Valuation
- Price to Earnings (P/E) Ratio (Leading P/E and Trailing P/E)
- Price to Book (P/B) Value Ratio and Equity Valuation
- Price to Sales (P/S) Ratio
- Price to Cash Flow Ratios
- Enterprise Value (EV) to EBITDA
- Dividend Yield for Valuing Equity
- Residual Income (RI) Valuation Model
Free Cash Flow Valuation
FCFF vs. FCFE Definitions
FCFF: Free Cash Flows to the Firm are available to both suppliers of equity and debt capital; return of these cash flows to stock and bond investors does not threaten the company’s existence as a going concern.
WACC & FCFF: When performing a company valuation using discounted FCFFs, the discount rate applied should be the weighted average cost of capital (based on the target capital structure), to reflect both the cost of equity and cost of debt.
Value0 \= Σ FCFFt / (1+WACC)t
Equity Value = Calculated Firm Value – Market Value of Debt
This can be converted to a share price by dividing the Equity Value by the number of shares outstanding.
FCFE: Free Cash Flows to Equity are available to stock holders only; return of these cash flows to stock investors does not threaten the company’s existence as a going concern.
Value0 \= Σ FCFEt / (1 + rce)t
The equity value derived from an FCFE analysis can then be divided by the number of shares outstanding to arrive at a share price.
Selecting FCFF or FCFE
The following situations can help an analyst decide which valuation approach is more appropriate:
- If the company has a consistent capital structure, then FCFE can be used in the valuation.
- If the company is highly leveraged and negative Free Cash Flows to Equity, then FCFF may be more appropriate.
- FCFF can be more appropriate when valuing a company that regularly changes its degree of financial leverage.
FCF Modeling vs. Dividend Discount Modeling (DDM)
Advantages and/or Appropriateness of FCF Valuation over DDM Valuation:
- FCF approaches can be applied companies that do not pay dividends.
- FCF approaches may be better for companies currently paying an unsustainable dividend.
- The FCFE model can be used when performing a valuation from a control perspective, as the majority owner will have discretion over how to use the equity cash flows; in contrast, DDM modeling may better reflect the view of a small shareholder who does not have control.
Calculating FCFF and FCFE
FCFF from Net Income
FCFF from Net Income = Net Income + Non-cash Charges + (Interest Expense * (1-tax rate)) – Fixed Capital Investment – Working Capital Investment
- This approach is sometimes called the “add-back” method.
- The most common non-cash charge would be depreciation, but there are others.
- Non-cash gains would need to be subtracted from net income.
FCFF from Cash Flow from Operations
FCFF from Cash Flow from Operations = CFO + (Interest Expense * (1-tax rate)) – Fixed Capital Investment
- The CFO approach should deliver the same results as the net income approach.
- When starting with CFO, analysts may still need to adjust for certain non-cash charges, such as restructuring charges.
FCFE from Net Income
FCFE from Net Income = Net Income + Non-cash Charges – Fixed Capital Investment – Working Capital Investment + Net Borrowing
Net Borrowing = New Debt – Principal Repayments
FCFE from Cash Flow from Operations
FCFE from Cash Flow from Operations = CFO – Fixed Capital Investment + Net Borrowing
Calculating FCFE from FCFF (and vice versa)
FCFE = FCFF – (Interest Expense * (1-tax rate)) + Net Borrowing
FCFF = FCFE + (Interest Expense * (1-tax rate)) – Net Borrowing
FCFF from EBIT and EBITDA
FCFF = (EBIT*(1-tax rate)) + Non-cash Charges – Fixed Capital Investment – Working Capital Investment
FCFF = (EBITDA*(1-tax rate)) + (Depreciation*(tax rate)) + Deferred Tax Increases – Fixed Capital Investment – Working Capital Investment
Once FCFF has been calculated, then it can be converted to FCFE, if the situation requires the FCFE value.
Reported Financials and the FCF Valuation Process
When deriving the working capital investment values for an FCF valuation, analysts should be mindful of the impacts of acquisitions, divestitures, and/or foreign subsidiary accounting as these items can complicate the relationship between the balance sheet and the statement of cash flows.
Other Cash Flow Issues for FCF Valuation
Share repurchases: Once a company performs a share repurchase, both FCFF and FCFE would decrease because those funds are not available to either debt or equity capital suppliers.
Issuing debt: Increases FCFE, but not FCFF
Issuing stock: Excluded from FCFF and FCFE
Erroneous FCF Proxies
- When performing valuations, analysts will sometimes inappropriately use net income, EBIT, or EBITDA as substitutes for cash flows.
- In an FCFF valuation, for example, EBITDA is problematic because it is pre-tax, it does not account for the tax shield of depreciation expense, and it does not account for fixed and working capital investments.
- In an FCFE valuation, EBITDA causes problems by ignoring net borrowing.
Preferred Stock Dividends
In the event that a company has issued preferred stock, the preferred dividends must be added back to FCFF; preferred dividends should not be added back for FCFE.
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