Free Cash Flow Valuation: Instructor: Abdul Rasheed Narejo, CFA

Chapter 4
Free Cash Flow Valuation
Instructor: Abdul Rasheed Narejo, CFA
SZABIST: Security Analysis – Jan-Apr 2011

Chapter 4 Discounted Cash Flow Valuation
A good business and a good investment are two different

things
WARREN BUFFET
What the wise does in the beginning, fool do in the end

WARREN BUFFET
SZABIST: Security Analysis – Jan-Apr 2011 2

Dividends & Cash Flow Valuation

• In the strictest sense, the only cash flow that an investor will receive from an
equity investment in a publicly traded firm is the dividend that will be paid on
the stock.
• Actual dividends, however, are set by the managers of the firm and may be
much lower than the potential dividends (that could have been paid out)
– managers are conservative and try to smooth out dividends
– managers like to hold on to cash to meet unforeseen future contingencies and
investment opportunities
• When actual dividends are less than potential dividends, using a model that
focuses only on dividends will under state the true value of the equity in a firm.
– Unlike dividend discount model, free cash flow models takes into considers all the
cash flows available to company’s shareholders

Measuring Potential Dividends

• Some analysts assume that the earnings of a firm represent its potential
dividends. This cannot be true for several reasons:
– Earnings are not cash flows, since there are both non-cash revenues and expenses in
the earnings calculation
– Even if earnings were cash flows, a firm that paid its earnings out as dividends would
not be investing in new assets and thus could not grow
– Valuation models, where earnings are discounted back to the present, will over
estimate the value of the equity in the firm
• The potential dividends of a firm are the cash flows left over after the firm has
made any “investments” it needs to make to create future growth and net debt
repayments (debt repayments - new debt issues)

Measuring Potential Dividends

• Accounting rules categorize expenses into operating and capital expenses. In
theory, operating expenses are expenses that create earnings only in the
current period, whereas capital expenses are those that will create earnings
over future periods as well. Operating expenses are netted against revenues to
arrive at operating income.
– There are anomalies in the way in which this principle is applied. Research and
development expenses are treated as operating expenses, when they are in fact
designed to create products in future periods.
• Capital expenditures, while not shown as operating expenses in the period in

which they are made, are depreciated or amortized over their estimated life.
This depreciation and amortization expense is a noncash charge when it does
occur.
• The net cash flow from capital expenditures can be then be written as:
Net Capital Expenditures = Capital Expenditures – Depreciation

When to use Free Cash Flow model

• Analysts like to use free cash flow (FCFF or FCFE) whenever one or more of the
following conditions is present:
– The company does not pay dividends
– The company paid dividends but dividends paid differ significantly from company’s
capacity to pay dividends
– Free cash flows align with profitability within a reasonable forecast period
– Investor takes control perspective
• If company’s capital structure (debt/equity ratio) is relatively stable, using FCFE

rather than FCFF is more simple.
• FCFF model is often chosen

– A leveraged company with negative FCFE
– A levered company with changing capital structure

Definition of FCFF & FCFE

• Free cash flow to the firm (FCFF) is the cash flow available to company’s
suppliers of capital (Debt + Equity) after,
– All operating expenses (including taxes) has been paid
– Necessary investment in working capital (e.g. inventory) and fixed assets (e.g.
equipment) has been made
– FCFF is cash flow from operations minus capex
• Free cash flow to equity (FCFE) is the cash flow available to company’s holders
of common equity after,
– All operating expenses, interest and principal payments have been made
– Necessary investment in working capital (e.g. inventory) and fixed assets (e.g.
equipment) has been made
– FCFE is FCFF less interest and principal payment on debt

Discounting the Free Cash Flow

Single Stage FCFF / FCFE Model

Computing FCFE from Net Income

Working Capital Effect

• In accounting terms, the working capital is the difference between current
assets (inventory, cash and accounts receivable) and current liabilities (accounts
payables, short term debt and debt due within the next year)
• A cleaner definition of working capital from a cash flow perspective is the

difference between non-cash current assets (inventory and accounts
receivable) and non-debt current liabilities (accounts payable). Any investment
in this measure of working capital ties up cash.
• Therefore, any increases (decreases) in working capital will reduce (increase)

cash flows in that period.
• When forecasting future growth, it is important to forecast the effects of such

growth on working capital needs, and building these effects into the cash flows.

Working Capital Effect

• Changes in non-cash working capital from year to year tend to be volatile. A far
better estimate of non-cash working capital needs, looking forward, can be
estimated by looking at non-cash working capital as a proportion of revenues.
• Some firms have negative non-cash working capital. Assuming that this will
continue into the future will generate positive cash flows for the firm. While
this is indeed feasible for a period of time, it is not forever. Thus, it is better
that non-cash working capital needs be set to zero, when it is negative.

Example: Working Capital

Example: International Industries (2009-10)
000’s 2010 2009
Non-cash Current Assets 8,687,670 3,932,323
Non-debt Current Liabilities 769,067 810,379
Working Capital 7,918,603 3,121,944

Key inputs for valuation

• Discount Rate
– Cost of Equity, in valuing equity
– Cost of Capital, in valuing the firm
• Cash Flows
– Cash Flows to Equity
– Cash Flows to Firm
• Growth (to get future cash flows)

– Growth in Equity Earnings
– Growth in Firm Earnings (Operating Income)

Estimating inputs: Discount Rate

• Critical ingredient in discounted cashflow valuation. Errors in estimating the
discount rate or mismatching cashflows and discount rates can lead to serious
errors in valuation.
• At an intuitive level, the discount rate used should be consistent with both the
riskiness and the type of cashflow being discounted.
– Equity versus Firm: If the cash flows being discounted are cash flows to equity, the
appropriate discount rate is a cost of equity. If the cash flows are cash flows to the
firm, the appropriate discount rate is the cost of capital.
– Currency: The currency in which the cash flows are estimated should also be the
currency in which the discount rate is estimated.
– Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e.,
reflect expected inflation), the discount rate should be nominal

Cost of Equity
• Estimating Risk Free Rate
– Risk Free Security (GoP)
• Estimating Equity Risk Premium

– Historical average
• Estimating Beta

Cost of Capital
• It will depend upon:
– (a) the components of financing: Debt, Equity or Preferred stock
– (b) the cost of each component
• In summary, the cost of capital is the cost of each component weighted by its
relative market value.
• WACC = ke (E/(D+E)) + kd (D/(D+E))

Cost of Debt
• The cost of debt is the market interest rate that the firm has to pay on its
borrowing. It will depend upon three components-
– (a) The general level of interest rates
– (b) The default premium
– (c) The firm's tax rate

What the cost of debt is not..

• The cost of debt is
– the rate at which the company can borrow at today
– corrected for the tax benefit it gets for interest payments.
• Cost of debt = kd = Interest Rate on Debt (1 - Tax rate)
• The cost of debt is not

– the interest rate at which the company obtained the debt it has on its Books.

Estimating Cost of Debt

• If the firm has bonds outstanding, and the bonds are traded, the yield to
maturity on a long-term, straight (no special features) bond can be used as the
interest rate.
• If the firm is rated, use the rating and a typical default spread on bonds with
that rating to estimate the cost of debt.
• If the firm is not rated,

– and it has recently borrowed long term from a bank, use the interest rate on the
borrowing or
– estimate a synthetic rating for the company, and use the synthetic rating to arrive at a
default spread and a cost of debt
• The cost of debt has to be estimated in the same currency as the cost of equity
and the cash flows in the valuation.

Calculating weights of each component

• Calculate the weights of each component
• Use target/average debt weights rather than project-specific weights.
• Use market value weights for debt and equity.

– The cost of capital is a measure of how much it would cost you to go out and raise the
financing to acquire the business you are valuing today.
• Since you have to pay market prices for debt and equity, the cost of capital is
better estimated using market value weights.
– Book values are often misleading and outdated.

Calculating weights of each component

• Estimating Market Value Weights
• Market Value of Equity should include the following

– Market Value of Shares outstanding
– Market Value of Warrants outstanding
– Market Value of Conversion Option in Convertible Bonds
• Market Value of Debt is more difficult to estimate because few firms have only
publicly traded debt. There are two solutions:
– Assume book value of debt is equal to market value
– Estimate the market value of debt from the book value

Profit & Loss statement

Rs Mil 2009 2010
Net Revenue 1,000 1,100
Less: cost of Goods Sold 750 825
= Gross Profit 250 275
Less: Selling & Admin Expenses 50 55
Plus: Other Operating Income 10 10
Less: Other Operating expenses 20 25
Operating Profit (EBIT) 210 235
Interest Expense 50 45
Profit Before Tax (PBT) 160 190
Tax expense @ 40% 64 76
Profit After Tax 96 114
EPS @ 10mn shares O/S 9.6 11.4
Dividend 6.4
Balance Sheet
Rs Mil 2009 2010 Rs Mil 2009 2010
Assets Liabilities & Equity
Gross: Property, Plant 700 725 Paid up Capital 100 100
& Equipment
Accumulated 200 250 Reserves 200 250
Depreciation Shareholders Equity 300 350
Net: Property, plant & 500 475
equipment Long Term Loan 200 150
Stores & spares 15 20 Accounts payables 40 50
Stock in Trade 25 30 Current Maturity of 50 50
Long term Loans
Trade debt 25 30 Trade debt
Cash & equivalent 25 45 Short term finance 0 0
Current Assets 90 115 Current Liability 90 100
Total Assets 590 590 Total Liability 590 600

Cash Flow Statement

2010
Operating Cash Flow
Net Profit 114
Add: Depreciation 50
Less: Net increase in stores & spares -10
Less: Increase in trade debts -5
Add: increase in accounts payable +10
= Operating Cash Flow =159
Less: Capex -25
Free Cash Flow to Firm =134
Less: Change in Net Debt -50
= Free Cash Flow to Equity =84
Less: Dividend 64
= Change in Cash & Equivalents 20
Formula for Free Cash Flow to Equity

Free Cash Flow to Equity

2010
Net Profit 114
Add: Depreciation 50
Less: Change in Working Capital -5
Less: Capex -25
Less: Debt Payment -50
= Free Cash Flow to Equity 84

Example: Estimating FCFE for Disney
• Net Income=$ 1,533 Million

• Capital spending = $ 1,746 Million
• Depreciation per Share = $ 1,134 Million
• Non-cash Working capital Change = $ 477 Million
• Net Debt Payment = $ 325 Million
• Estimating FCFE (1997):
– Net Income $1,533 Mil
+ Depreciation $1,134 Mil
– Capex $1,746 Mil
– Chg. Working Capital $477 Mil
– Debt Repayment $325 Mil
= Free CF to Equity $119 Mil

Example: Estimating FCFE for FFC

Rs Million 2009 2010
Free Cash Flow to Equity 2010
Net Income 11,029
Net income 11,029
Depreciation 1,194
+ Depreciation 1,194
Capex 3,314
-Capex -3,314
Non-cash Current Assets 4,300 4,014
- Change in WC +3,527
Non-interest Current 9,820 13,041
Liabilities - Debt Payment +5,377
Working Capital -5,500 -9027 FCFE 17,813
Total Debt 12,613 17,990

Value of Equity, EV, Debt & Investments
Enterprise Value (EV) = Value of equity + Value of Debt – Excess Cash/ Investments
Value of Equity = FCFE0 (1 + g ) / (r – g) => discounted value of FCFE

Value of Firm (EV) = FCFF 0 (1+g) / (r – g) => discounted value of FCFF
Value of Equity = Value of Firm – Value of Debt + Excess Cash / Investments
Assets Liabilites & Equity

Property, Plant & Equipment 50 Equity 40
Investments 25 Debt 35
Current Assets 25 Current Liabilities 25
Total 100 Total 100

Computing FCFF/FCFE from Net income

Free cash Flow to Firm Free Cash Flow to Equity
= Net Income = Net Income
Plus: Non-cash charges (Depreciation) Plus: Non-cash charges (Depreciation)
Plus: Interest expense (1 – tax) Less: Fixed Capital Expenditure
Less: Fixed Capital Expenditure Less: Increase in working Capital
Less: Increase in working Capital Plus: Increase in Debt
FCFE = FCFF – Interest (1 – Tax) + Net borrowing
FCFF = FCFE + Interest (1 – Tax) – Net borrowing

Computing FCFF/FCFE from Operating Cash Flow

= Operating Cash Flow = Net Income
Plus: Interest expense (1 – tax) Plus: Increase in Debt
Less: Fixed Capital Expenditure Less: Fixed Capital Expenditure
FCFE = FCFF – Interest (1 – Tax) + Net borrowing
FCFF = FCFE + Interest (1 – Tax) – Net borrowing

Computing FCFF/FCFE from EBIT

= EBIT (1 – tax) = EBIT ( 1 – tax)
Plus : Non-cash charges (depreciation) Plus : Non-cash charges (depreciation)
Less: Fixed Capital Expenditure Plus: Interest expense (tax)
Less: Increase in working Capital Less: Increase in working Capital
Plus increase in debt
FCFE = FCFF – Interest (1 – tax) + Net borrowing)

Computing FCFF/FCFE from EBITDA

= EBITDA (1 – tax) = EBITDA (1 – tax)
Plus: Depreciation (tax) Plus: Depreciation (tax)
Less: Fixed Capital Expenditure Less: Fixed Capital Expenditure
Less: Increase in working Capital Less: Increase in working Capital
Less: Interest (1-tax)
Plus: Net borrowing
FCFE = FCFF – Interest (1 – tax) + Net borrowing)

Example 2
• Find FCFF /FCFE

– Net Income $285 Mil
– depreciation rate $180 Mil
– Capex $349 Mil
– Change in working capital 661 – 623 = $38
– Interest Expense $130 Mil
– Tax Rate 40%
– Increase in Debt $50 Mil
• Find FCFF /FCFE
• FCFE = Net Profit + Depreciation – Capex – Increase in Working Capital + Debt Issue
– = 285 + 180 – 349 – 38 + 50 = $128 Mil
• FCFF = Net Profit + Interest ( 1 – Tax) + Depreciation – Capex – Increase in Working Capital
– = 285 + 130 (1-40%) + 180 – 349 – 38 = $156 Mil


Free Cash Flow Valuation: Instructor: Abdul Rasheed Narejo, CFA

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Chapter 4

Free Cash Flow Valuation

Instructor: Abdul Rasheed Narejo, CFA

SZABIST: Security Analysis – Jan-Apr 2011

A good business and a good investment are two different

What the wise does in the beginning, fool do in the end

SZABIST: Security Analysis – Jan-Apr 2011 2

Dividends & Cash Flow Valuation

SZABIST: Security Analysis – Jan-Apr 2011 3

Measuring Potential Dividends

SZABIST: Security Analysis – Jan-Apr 2011 4

Measuring Potential Dividends

• Capital expenditures, while not shown as operating expenses in the period in

Net Capital Expenditures = Capital Expenditures – Depreciation

SZABIST: Security Analysis – Jan-Apr 2011 5

When to use Free Cash Flow model

• If company’s capital structure (debt/equity ratio) is relatively stable, using FCFE

• FCFF model is often chosen

SZABIST: Security Analysis – Jan-Apr 2011 6

Definition of FCFF & FCFE

SZABIST: Security Analysis – Jan-Apr 2011 7

Discounting the Free Cash Flow

SZABIST: Security Analysis – Jan-Apr 2011 8

Single Stage FCFF / FCFE Model

SZABIST: Security Analysis – Jan-Apr 2011 9

Computing FCFE from Net Income

SZABIST: Security Analysis – Jan-Apr 2011 10

Working Capital Effect

• A cleaner definition of working capital from a cash flow perspective is the

• Therefore, any increases (decreases) in working capital will reduce (increase)

• When forecasting future growth, it is important to forecast the effects of such

SZABIST: Security Analysis – Jan-Apr 2011 11

Working Capital Effect

SZABIST: Security Analysis – Jan-Apr 2011 12

Example: Working Capital

SZABIST: Security Analysis – Jan-Apr 2011 13

Example: International Industries (2009-10)

000’s 2010 2009

Non-cash Current Assets 8,687,670 3,932,323

Non-debt Current Liabilities 769,067 810,379

Working Capital 7,918,603 3,121,944

SZABIST: Security Analysis – Jan-Apr 2011 14

Key inputs for valuation

• Growth (to get future cash flows)

SZABIST: Security Analysis – Jan-Apr 2011 15

Estimating inputs: Discount Rate

SZABIST: Security Analysis – Jan-Apr 2011 16

• Estimating Equity Risk Premium

SZABIST: Security Analysis – Jan-Apr 2011 17

– (b) the cost of each component

• WACC = ke (E/(D+E)) + kd (D/(D+E))

SZABIST: Security Analysis – Jan-Apr 2011 18

– (b) The default premium

– (c) The firm's tax rate

SZABIST: Security Analysis – Jan-Apr 2011 19

What the cost of debt is not..

– corrected for the tax benefit it gets for interest payments.

• Cost of debt = kd = Interest Rate on Debt (1 - Tax rate)

• The cost of debt is not

SZABIST: Security Analysis – Jan-Apr 2011 20

Estimating Cost of Debt

• If the firm is not rated,