Set out ways of projecting FCFF and FCFE
The idea
Free cash flow can be forecast in two broad ways. The simpler grows the latest free cash flow at a constant rate, which assumes the relationships among its components never change. The more detailed way forecasts the components: sales growth drives operating profit through a margin, and fixed and working capital investment are set as percentages of the increase in sales. For FCFE, borrowing is often modelled with a target debt ratio DR, so that debt funds that share of net new investment: FCFE = NI − (1 − DR) × (FCInv − depreciation) − (1 − DR) × WCInv. The trap is using gross capital spending in place of capital spending net of depreciation in that formula, which overstates the equity financing required.
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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
- Work out 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