Work out FCFF and FCFE
The idea
Calculating free cash flow means starting from a reported figure and making the right adjustments. FCFF from net income is NI + non-cash charges + interest × (1 − t) − FCInv − WCInv. FCFE is FCFF − interest × (1 − t) + net borrowing, or directly NI + non-cash charges − FCInv − WCInv + net borrowing. Fixed capital investment is capital spending less proceeds from asset sales. Working capital investment is the rise in current assets excluding cash, less the rise in current liabilities excluding short-term debt. Non-cash charges include depreciation, amortisation and impairments, while gains on disposals are deducted. The common traps are adding back interest before tax and treating an increase in working capital as a source of cash.
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- Contrast valuing a business by the free cash flow available to equity (FCFE) with valuing it by its free cash flow to the whole firm (FCFF)
- Explain whose point of view as owner the FCFE approach takes
- Explain which adjustments turn EBIT (pre-interest, pre-tax earnings), EBITDA, net income and operating cash flow (CFO) into FCFF and FCFE
- Set out ways of projecting FCFF and FCFE
- Explain how dividends, buybacks, new share issues and shifts in leverage can change future FCFF and FCFE
- Contrast the FCFE model with dividend discount models
- Assess using EBITDA and net income as stand-ins for cash flow when valuing a firm
- Explain how sensitivity analysis is used in FCFF and FCFE valuation
- Explain FCFF and FCFE models with one stable-growth stage, two stages and three stages, and argue which suits a given firm's characteristics
- Estimate what a firm is worth with the free cash flow model or models that fit it
- Set out ways of working out terminal value in a valuation model with several stages
- Judge from a free cash flow valuation whether a stock is priced too high, too low or fairly