Recap Free cash flow AMZN versus McD Firm Value Synthesis

Free cash flow (FCF) and Firm Value

Shashwat Alok

Indian School of Business

June 2024
Recap Free cash flow AMZN versus McD Firm Value Synthesis

Agenda

1 Recap

2 Free cash flow

3 AMZN versus McD

4 Firm Value
Implementation

5 Synthesis
Firm value and NPV
Recap Free cash flow AMZN versus McD Firm Value Synthesis

Investment Decisions

• Objective: shareholder value maximization

• Investment decisions: NPV Rule

• NPV = FCFt
P
t (1+rt )t

• FCF = Free Cash Flow (Expected)

• Discount rate = Expected Return=cost of capital

• CAPM

• This class:

• How to estimate free cash flow

Recap Free cash flow AMZN versus McD Firm Value Synthesis

The market value balance sheet - breakdown

Recap Free cash flow AMZN versus McD Firm Value Synthesis

Free cash flow defined

• Here, free means “uncommitted” or “available”

• Does not mean “without cost”

• Remember: Every dollar of capital has an opportunity cost

• Definition of free cash flow (FCF):

FCF=NOPAT + noncash operating expenses-Investment in invested capital

• Noncash operating expenses is typically depreciation

• Definitions of NOPAT and invested capital follow

Recap Free cash flow AMZN versus McD Firm Value Synthesis

NOPAT
• NOPAT= Net operating profit after taxes

• After-tax profit generated from core operations

• excluding any income from non-operating assets (interest earned on

excess cash or investments)
• excluding any expenses such as financing expenses, e.g., expenses

• Idea of NOPAT:

• Accounting net income is the PAT available only to equity (share)

holders only
• NOPAT is the profit available to all providers of capital – debt,
equity and others
• NOPAT is independent of capital structure (Debt/Equity Mix)
• Debt is ignored completely in FCF calculations.

• NOPAT = EBIT (1 − τc ) is often used, with an assumed tax rate τc

Recap Free cash flow AMZN versus McD Firm Value Synthesis

Invested capital

• Must reflect only assets (current as well as long term) invested for operations

• Typically consists of fixed assets and working capital...

• ...which is why Investment in invested capital (per year) is often written:

Capital expenditure+change in net working capital

• Investment in invested capital=Capex + ∆NWC

Recap Free cash flow AMZN versus McD Firm Value Synthesis

Bottom line

• Definition of free cash flow

• FCF=NOPAT +noncash operating expenses-Investment in invested capital

• Most of the time boils down to:

• FCF=EBIT (1 − τc )+ Depreciation −Capex − ∆NWC

Recap Free cash flow AMZN versus McD Firm Value Synthesis

Forecasting future cash flows

• Revenue projections
• For existing products: estimated future size of the industry, likely
market share, .
• For new industries: size of the target demograhic and likely
penetration.
• Competition from existing players, threat of new entrants and new
products
• Cost projections
• Changing technology
• Cost of inputs

• Net working capital is often a percentage of sales revenue. As sales

grow, additional investment in NWC is needed. As sales decline,
NWC can be partly recovered.
• Similar businesses or own history can be useful starting points.
Recap Free cash flow AMZN versus McD Firm Value Synthesis

Estimating Unlevered Free Cash Flow

Recap Free cash flow AMZN versus McD Firm Value Synthesis

The old and the new

• McDonald’s was the hot stock in the 1970s/1980s

• Amazon is the hot stock of the 2000s/2010s

• Let’s calculate their profits and free cash flows

• Talk our way through the economics behind the numbers

Recap Free cash flow AMZN versus McD Firm Value Synthesis

Enterprise and Equity value

• Enterprise value =PV (Free cash flows) + PV (Terminal Value)

• This is the value generated by the firm’s operations

• Equity value =Enterprise value + Net non-operating assets - Debt

• Share price = Equity value

No. of shares
Recap Free cash flow AMZN versus McD Firm Value Synthesis

Steps in DCF Valuation

Forecast Unlevered Free Cash Flows (FCF) during forecast horizon

• forecast horizon is typically the stage of high-growth
Estimate Residual (post-horizon) Value aka “Terminal Value”
Discount everything back at the WACC This gives you the Value from
Operations.aka Enterprise Value
Add value of cash + marketable securities
[-] This gives you the Value of the Firm (which includes both the claims
of both equity and debt holders).
Subtract market value of Financial Debt (including preferred stock, stock
options) to get the value of equity
(1)
Recap Free cash flow AMZN versus McD Firm Value Synthesis

Algorithm

• Enterprise value,
FCF1 FCF2 FCFT TVT
V0 = (1+WACC ) + (1+WACC )2 + ··· + (1+WACC )T
+ (1+WACC )T
,

• where, Terminal value,

FCFT +1 FCFT (1+g )
TVT = (WACC −g ) = (WACC −g )

•
Recap Free cash flow AMZN versus McD Firm Value Synthesis

Terminal value

• Why do we need a terminal value?

• Because financial projections need to be made

• One can credibly make projections only for T (say, 5) years (forecast horizon)

Source: http://mindandmarket.blogspot.com
Recap Free cash flow AMZN versus McD Firm Value Synthesis

More on the terminal value

• Given a forecast horizon T , everything else from that point on forever is lumped
together as Terminal value at time T
• Terminal value (TV) = PV(all FCFs beyond forecast horizon)

• In practice, we compute TV as either:

• Salvage value: Current book value ± adjustments to reflect true economic

depreciation

• Going concern or Continuing value

• PV of a growing perpetuity beginning at T and stable growth rate g

• Stable Growth Cap: For an average company, the stable growth rate g should
be ≤to the long-term (real) growth rate of the economy plus long-term
inflation = nominal growth rate of the economy
• [-] Growth rates can exceed the cost of capital (aka discount rate) in the
forecast horizon. However, in the stable period, growth rates will be lower than
the discount rate.

• Using multiples of comparables (Later courses.)

Recap Free cash flow AMZN versus McD Firm Value Synthesis

Firm value and Net present value

• From all we have seen, enterprise value is the present value of all firm free cash flows
– from next year to infinity and beyond

• Where will these future free cash flows come from?

• Existing projects

• New projects

• Therefore, we interpret the firm’s enterprise value as

• The total NPV to the firm from continuing its existing projects and initiating new ones

• The sum total of the NPVs of each project in the firm, current and future

• The above two statements are equivalent as NPVs are additive!

Recap Free cash flow AMZN versus McD Firm Value Synthesis

Firm value and NPV: Implication

• Firm value is the sum total of the NPVs of every project in the firm, current and future

• Common implication: To maximize the firm’s shareholder value, we must accept

projects that have a positive NPV
Recap Free cash flow AMZN versus McD Firm Value Synthesis

Caveat

• Positive NPV projects

• are not abundant

• are fewer in more competitive industries

• arise from advantages that may not last

• [-] reduce as firms age

• Consider these limitations as a reality check on your cash flow projections