Free Cash Flow

Valuation
Last Week
• FCFF = NI + Dep + Int(1-Tax rate) – FCInv – WCInv
• FCFF = EBIT (1-tax rate) + Dep – FCInv – WCInv
• FCFF = EBITDA (1-tax rate) + Dep (tax rate) –
FCInv – WCInv
• FCFF = CFO + Int(1-Tax rate) - FCInv

• FCFE = NI + Dep – FCInv – WCInv + Net borrowing

• FCFE = FCFF - Int(1-Tax rate) + Net borrowing
• FCFE = CFO – FCInv + Net borrowing
 FCFF = NI + Dep + Int(1-Tax rate) – FCInv – WCInv
FCFE = NI + Dep – FCInv – WCInv + Net borrowing
In what context do we use
FCF?
• FCF for a past period helps in explaining what happened at
a business during that period, in operating, investing and
financing terms

• FCF computed for a past period can be used as the basis for
valuation by forecasting expected FCF in the future

• Within a multiple FCF as a base can be used to compare

pricing across companies, where the market price is scaled
to FCF, rather than earnings
▫ FCFE/Sales
▫ FCFE/Net Income (earnings)
▫ P per share/ FCFE per share
▫ FCFE Dividend Coverage Ratio = FCFE / Dividends Paid
FCFE and Cash Balances
FCFF
Intrinsic Valuation
 FCFF = NI + Dep + Int(1-Tax rate) – FCInv – WCInv
FCFE = NI + Dep – FCInv – WCInv + Net borrowing

Other Noncash Adjustments• Add back

Depreciation

• Add back
Amortization

• Add back … typically once off costs

Restructuring Expense

• Subtracted out … typically one time income

Restructuring Income

• Subtract out .. Nonoperating income so

Capital Gains
doesn’t impact ongoing cash generation
• Add back ..nonoperating expense
Capital Losses

• Add back … the company gets cash but it is

Employee Option Exercise
not included in NI so you are adding it

• if there is an increase in deferred tax liability

Deferred Taxes
then add back NI as tax are expenses but not
• Subtract out? – if it reduces the cash tax
Tax Asset
payments and this benefit is not reflected in
NI, then add back
Applying DCF to FCF
 
FCFEt
Equity value   t
t 1 1  r 

Single Stage Constant Growth

Multiple Stage Growth:

𝑛
𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒= ∑ 𝐹𝐶𝐹 𝐸 0 ¿ ¿ ¿
𝑡=1
 
FCFFt
Firm value   t
t 1 1  WACC 

Equity value Firm value  Debt value

Single Stage Constant Growth

 Example: Single-Stage FCFF
Model
Current FCFF $6,000,000
Target debt to capital 0.25
Market value to debt $30,000,000
Shares outstanding 2,900,000
Required return on 12%
equity
Cost of debt 7%
Long-term growth in 5%
FCFF

Note:
Tax rate Firm value = 30%
capital is capital employed = debt + equity
Target debt to capital 0.25
Required return on 12%
equity
Cost of debt 7%
Tax rate 30%

 MV(Debt)  
WACC    rd (1  Tax rate) 
  MV(Equity)  MV(Debt)  
 MV(Equity)  
  r 
  MV(Equity)  MV(Debt)  

WACC  0.25 7% (1  0.30)    0.75 12%  10.23%

Current FCFF $6,000,000
Market value to debt $30,000,000
Shares outstanding 2,900,000
Long-term growth in 5%
FCFF
WACC 10.23%

Firm value =

Firm value = = $120.5 million

Equity value = $120.5 million – $30 million = $90.5 million

Equity value per share = $90.5 million/2.9 million = $31.21

FCFE = NI + Dep – FCInv – WCInv + Net borrowing

A Lifecycle Perspective on FCF

Forecasting FCFF and
FCFE
Forecasting FCFF and FCFE
• Three approaches are commonly used to forecast FCFF and
FCFE:

1. Use historical free cash flow and apply a growth rate under the
assumptions that growth will be constant and firm
fundamentals are unchanged.

2. Forecast the underlying components of free cash flow and

apply multi-stage model. See Heritage case
3. Forecast the underlying components of free cashflow. This
relates sales growth to future capital expenditures, depreciation
expenses, and changes in working capital.
 Question
Sean is evaluating BallyG using the FCFF and FCFE valuation approaches. BallyG has
collected the following information (currency in euros):
 BallyG has net income of €250 million, depreciation of €90 million, capital
expenditures of €170 million, and an increase in working capital of €40 million.
 BallyG will finance 40 percent of the increase in net fixed assets (capital
expenditures less depreciation) and 40 percent of the increase in working capital
with debt financing.
 Interest expenses are €150 million. The current market value of BallyG's
outstanding debt is €1,800 million.
 FCFF is expected to grow at 6.0 percent indefinitely, and FCFE is expected to grow
at 7.0 percent.
 The tax rate is 30 percent.
 BallyG is financed with 40 percent debt and 60 percent equity. The before-tax cost
of debt is 9 percent, and the before-tax cost of equity is 13 percent.
 BallyG has 10 million outstanding shares.
A Using the FCFF valuation approach, estimate the total value of the firm, the
total market value of equity, and the per-share value of equity.

B Using the FCFE valuation approach, estimate the total market value of equity
and the per-share value of equity.
 BallyG has net income of €250 million, depreciation of €90 million, capital
expenditures of €170 million, and an increase in working capital of €40
million.
 Interest expenses are €150 million.
 The tax rate is 30 percent.
  The tax rate is 30 percent.
 BallyG is financed with 40 percent debt and 60 percent equity. The before-tax
cost of debt is 9 percent, and the before-tax cost of equity is 13 percent.

• WACC = 0.40*9%(1 − 0.30) + 0.60*13% = 10.32%

FCFF = 235 m
WACC = 10.32%

 FCFF is expected to grow at 6.0 percent indefinitely

FCFF = 235 m
WACC = 10.32%
Firm Value = 5766.20

 Interest expenses are €150 million. The current market value of BallyG's
outstanding debt is €1,800 million.
 BallyG has 10 million outstanding shares.

• FCFE = €5,766.20 million − €1,800 million

= €3,966.20 million

• Per share estimate of V0 = €3,966.20 million/10 million

= €396.62 per share
 BallyG has net income of €250 million, depreciation of €90 million, capital
expenditures of €170 million, and an increase in working capital of €40 million.

 BallyG will finance 40 percent of the increase in net fixed assets (capital
expenditures less depreciation) and 40 percent of the increase in working capital
with debt financing.
FCFE = 178 m

 FCFF is expected to grow at 6.0 percent indefinitely, and FCFE is expected to

grow at 7.0 percent.
 The before-tax cost of debt is 9 percent, and the before-tax cost of equity is 13
percent.
 BallyG has 10 million outstanding shares.

Value per share is V0 = €3,174.33 million/10 million =

€317.43 per share.
Forecasting FCFF and FCFE
• Three approaches are commonly used to forecast FCFF and
FCFE:

1. Use historical free cash flow and apply a growth rate under the
assumptions that growth will be constant and firm
fundamentals are unchanged.

2. Forecast the underlying components of free cash flow and

apply multi-stage model. See Heritage case
3. Forecast the underlying components of free cash flow. This
relates sales growth to future capital expenditures, depreciation
expenses, and changes in working capital.
Heritage
Foods:
Discounted
Cash Flow
Valuation.

Current Price: INR 1400

Forecasting FCFF and FCFE
• Three approaches are commonly used to forecast FCFF and
FCFE:

1. Use historical free cash flow and apply a growth rate under the
assumptions that growth will be constant and firm
fundamentals are unchanged.

2. Forecast the underlying components of free cash flow and

apply multi-stage model. See Heritage case
3. Forecast the underlying components of free cash flow. Relate
sales growth to future capital expenditures, depreciation
expenses, and changes in working capital.
• Capital expenditures are assumed to have two components:
• outlays needed to maintain existing capacity (fixed capital
replacement) and
• outflows needed to support growth.

• The first outlay is related to the current level of sales

and
• The second depends on the predicted sales growth.
FCFF = NI + Dep + Int (1-tax rate) – FCInv – WCInv

• Can be written as
• FCFF = NI + Int (1-tax rate) – (FCInv – Dep) –
WCInv
• FCFF = NI + Int (1-tax rate) – (net capex) –
WCInv

• FCFF = NI + Int (1-tax rate) – reinvestment

FCFE = NI + Dep – FCInv – WCInv + Net borrowing
FCFE = NI – (FCInv – Dep) – WCInv + Net borrowing
FCFE = NI – (net capex) – WCInv + Net borrowing
FCFE = NI – reinvestment + Net borrowing
 FCFE = NI – (FCInv – Dep) – WCInv + Net borrowing

When forecasting FCFE, there is a shortcut for FCFE if we

assume that a firm maintains a constant target debt financing
ratio (DR) for net new investment in fixed capital and working
capital.
This assumption allows forecasts of FCFE without having to
specifically forecast debt issuance or repayment.

FCFE = NI – (FCInv – Dep) – WCInv

FCFE = NI – (1-DR)(FCInv- Dep) – (1-DR)(WCInv)
Where DR = target debt ratio

•Rem
• maintaining existing capacity is related to current level of sales
• growth is related to predicted sales growth
Example: Forecast FCFF1 and FCFE1
Sales0 $4,000
Sales growth each time period $200
EBIT0 $600
Constant tax rate 30%
Purchases of fixed assets $800
Depreciation expense $700
Change in working capital $50
Net income margin 10%
Constant Debt ratio 40%
Assume all margins are constant
• FCFF = NI + Dep + Int (1-tax rate) – FCInv – WCInv

In this question we do not have NI or interest. We have EBIT.

• FCFF = EBIT (1-tax rate) + Dep – FCInv – WCInv

• FCFF = EBIT (1-tax rate) - (FCInv- dep) – WCInv

▫ FCFF1 = EBIT1 (1-tax rate1) - (FCInv- dep)1 – WCInv1

 FCFF1 = EBIT1 (1-tax rate1) - (FCInv- dep)1 – WCInv1

Task 1: Forecast EBIT1 (1-tax rate).

EBIT1 = Sales1 * EBIT Margin

▫ Sales0 = $4000 and Sales growth = $200

▫ Sales1 = 4000+200 = 4200

▫ Sales0 = $4000 and EBIT0 = $600

▫ EBIT margin = 600/4000 = 15%

▫ EBIT1 = 4,200 (0.15) = 630

Forecast EBIT1(1-tax rate)

▫ 630(1-0.30) = 441
 FCFF1 = EBIT1 (1-tax rate1) - (FCInv- dep)1 – WCInv1

• Task 2: Forecast FCInv

▫ Fixed assets0 = 800 and Dep0 = 700

▫ net capex0 = (800-700) = 100
▫ As a percentage of sales growth: 100/200 =
50%

• FCInv = sale growth * FCInv %

• FCInv = 200*50% = 100
 FCFF1 = EBIT1 (1-tax rate1) - (FCInv- dep)1 – WCInv1

• Task 3: Forecast WCInv

▫ Change in WC = 50
▫ As a percentage of current sales: 50/200 =
25%

 WCInv = 200*25% = 50
 FCFF1 = EBIT1 (1-tax rate1) - (FCInv- dep)1 – WCInv1

• Task 4: calculate FCFF

▫ FCFF= 441-100-50 = 291

• FCFE1 = NI – (1-DR)(FCInv- Dep) – (1-DR)
(WCInv)
▫ Debt ratio = 40%

• FCFE = NI – (1-.40)(800-700) – (1-.40)(50)

▫ NI = sales* net income margin

▫ NI = 4200*10% = 420

• FCFE = 420 – (1-.40)(800-700) – (1-.40)(50)

• FCFE = 330
Multistage Models
 Simple Two-Stage FCF Models
𝑛
𝐹𝑖𝑟𝑚𝑉𝑎𝑙𝑢𝑒 : 𝑉 0=∑ 𝐹𝐶𝐹 𝐹 0 ¿ ¿ ¿
𝑡=1

𝑛
𝐹𝐶𝐹 𝐹 𝑡
𝐹𝑖𝑟𝑚𝑉𝑎𝑙𝑢𝑒 : 𝑉 0= ∑ ¿
𝑡=1
¿¿

𝑛
𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒 : 𝑉 0 =∑ 𝐹𝐶𝐹 𝐸 0 ¿ ¿ ¿
𝑡 =1
Two stage model: Calculate the value per share

Current sales per share $10

Sales growth for first three years 20%
Sales growth for year 4 and thereafter 5%
Net income margin 10%
FCInv/Sales growth 40%
WCInv/Sales growth 25%
Debt financing of FCInv and WCInv growth 30%
Required return on equity 12%

Note how the values are per

• FCFE = NI - FCInv - WCInv + net borrowing
▫ NI = sales *net income margin

▫ Current sales = $10

▫ Sales growth for first three years = 20%

▫ Sales1 = Sales0 (1 + sales growth rate) = 10*(1+0.2) = $12

 Sales growth in $ = 12-10 = $2

▫ NI =sales *net income margin

 Net income margin = 10%
▫ NI =$12*10% = $1.20
• FCFE = NI - FCInv - WCInv + net borrowing
• FCFE = 1.20 - FCInv - WCInv + net borrowing

• FCInv = sales * FCInv/Sales growth

• FCInv = 2 * 40% = 0.80

• WCInv= sales * WCInv/Sales growth

• WCInv= 2*25% = 0.50
• FCFE = NI - FCInv - WCInv + net borrowing
• FCFE = 1.20 – 0.80 – 0.50 + net borrowing

▫ Debt financing of FCInv and WCInv growth =30%

 Sales growth = $2
 To finance this growth we re-invest 40% FC and 25% in WC (40%
+25%) = 65% reinvested
 We finance 30% of this investment with debt
 = ($2)*(.65)*(.3) = 0.39
• FCFE = NI - FCInv - WCInv + net borrowing
• FCFE = 1.20 – 0.80 – 0.50 + 0.39
• FCFE1 = $0.29

This is a multistage model, so I still need FCFE2 etc

Alternative way of writing the soln…

FCFE = EPS - FCInv - WCInv + net borrowing

FCFE = (12*10%) – (2*40%) – (2*25%) + (2*65%*30%)

FCFE = 1.20-0.80-0.50+0.39

FCFE1 = $0.29
Example: Simple Two-Stage FCFE Model
FCFE = EPS - FCInv - WCInv + net borrowing

Year
1 2 3 4 5
Percentage sales growth 20% 20% 20% 5% 5%
Sales per share $12.000 $14.400 $17.280 $18.144 $19.051
EPS $1.200 $1.440 $1.728 $1.814 $1.905
FCInv per share $0.800 $0.960 $1.152 $0.346 $0.363
WCInv per share $0.500 $0.600 $0.720 $0.216 $0.227
Debt financing per share $0.390 $0.468 $0.562 $0.168 $0.177
FCFE per share $0.290 $0.348 $0.418 $1.421 $1.492
Growth in FCFE 20.0% 20.0% 240.3% 5.0%
Two stage model: Calculate the value
per share

n
FCFE 0 (1  g s ) t FCFE 0 (1  g s ) n (1  g L )
EquityValu e : V0  
t 1 (1  r ) t
r  g L (1  r ) n

Required return on equity 12%

0.29 0.348 0.418 1.421

V0    
(1.12)1 (1.12) 2 (1.12) 3 (0.12  0.05)(1.12) 3

V0 $15.28
 Declining Growth
Two-Stage FCFE Model

Initially
High earnings Large capital Low or negative
growth expenditures FCFE

Competition Later
Increases
Capital
Earnings
expenditures FCFE increases
growth slows
decline
• Sometimes to calculate the terminal value
we use ratios. For example terminal value
is 8 times earnings

• Terminal value is
 Issues in FCF Analysis
Financial Statement Discrepancies

Dividends vs. FCFE

Effect of Shareholder Cash Flows and
Leverage
FCFF and FCFE vs. EBITDA and Net Income

Country Adjustments

Sensitivity Analysis

Nonoperating Assets
Reading - Pinto (2019) Equity valuation A survey of
professional practice

• Survey of equity valuation practices

• A neutral survey of current practice in

equity valuation.
• 38 questions
• Respondent traits were gathered
• Almost 2,000 responses
• Global reach included responses of analysts
based in North America, Europe, and Asia.
In evaluating individual equity securities, which of the following approaches to
valuation do you use? (N= 1,980)

Percent of Percentage of cases

respondents respondents
use each approach
(mean)
A market multiples approach 92.8 68.6
A present discounted value 78.8 59.5
approach
An asset‐based approach 61.4 36.8
A (real) options approach 5.0 20.7
Other approach 12.7 58.1
When you use a present discounted value model approach, which of the
following models do you use? (N= 1,457)

Percent of Percentage of cases

respondents respondents
use each approach
(mean)
Dividend discount model 35.1 51.7
Residual income 20.5 46.1
Discounted free cash flow 86.8 80.1
model
Cash flow return on 19.7 58.5
investment (CFROI®)
model
Other 3.6 71.3
 When you use a present discounted value model, which of the following
approaches for estimating the required return on equity (the cost of equity)
for use in such a model do you use? (N= 1,436)

Percent of Percentage of cases

responden respondents
ts use each approach
(mean)
The capital asset pricing model 68.2 77.5
(CAPM)
Arbitrage pricing theory (APT) 4.8 47.0
model
Fama‐French or related model 4.0 42.2
Bond yield plus a risk premium 42.7 61.4
A judgmentally determined hurdle 47.5 64.3
rate
Other 6.3 79
When you use a dividend discount model to value equity, which of the following
models do you use? (N= 500)

Percent of Percentage of cases

respondents respondents
use each approach
(mean)
Single‐stage (“constant 40.6 65.5
growth”) model
Two‐stage model 55.2 67.6
H‐model 10.6 48.2
More than two‐stage model 50.4 73.5
Other 2.4 77.0
When you use a discounted free cash flow approach, which of the
following models do you use? (N= 1,209)
Percent of Percentage of cases
respondents respondents
use each approach (mean)
Single‐stage (“constant 22.6 58.8
growth”) free cash flow to the
firm
Two‐stage free cash flow to 43.8 70.0
the firm
H‐model free cash flow to the 6.2 44.8
firm
More than two‐stage free 40.5 72.9
cash flow to the firm
Single‐stage (“constant 11.8 46.8
growth”) free cash flow to
equity
Two‐stage free cash flow to 21.1 57.7
equity
H‐model free cash flow to 4.4 38.2
equity
• FCFF more popular than FCFE

• H model not too popular

• Analysts forecast forward median of 5 yrs

then get terminal value