Explained: Free cash flows, types, and valuation
As free cash flows provide a sound basis for evaluation, it is often considered that free cash flow models are more useful than DDM models, in practice.
Discounted cash flow, which is popularly known as DCF valuation, denotes the intrinsic value of a security as the present value of its expected future cash flows. When applied to dividends, the DCF model is the discounted dividend approach or dividend discount model (DDM).
We can extend DCF analysis to value a company and its equity securities in the form of valuation of free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). The dividends are the cash flows actually paid to stockholders whereas free cash flows are the cash flows available for distribution to shareholders.
Types of free cash flows
Free cash flow to the firm (FCFF): It represents the amount of cash flow from operations available for distribution after accounting for depreciation expenses, taxes, working capital, and investments. FCFF is a measurement of a company's profitability after all expenses and reinvestments.
The calculation for FCFF can take several forms. The most common equation is the following:
FCFF = NI + NC + (I × ( 1 − TR )) − LI − IWC
where:
NI=net income
NC=non-cash charges
I=interest
TR=tax rate
LI=long-term investments
IWC=investments in working capital
Free cash flow to the equity: Free cash flow to equity is a measure of how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt is paid. FCFE is a measure of equity capital usage.
It can easily be derived from a company’s statement of cash flows using the formula:
FCFE = cash from operating activities – capital expenditures + net debt issued (repaid)
Valuation of FCFE and FCFF
The two distinct approaches to using free cash flow for valuation are the FCFF valuation approach and the FCFE valuation approach. The general expressions for these valuation models are similar to the expression for the general dividend discount model.
FCFF valuation approach estimates the value of the firm as the present value of future FCFF discounted at the weighted average cost of capital:
Firm value = FCFF / [(1+WACC)^t]
As FCFF is the cash flow available to all suppliers of capital, making use of the weighted average cost of capital (WACC) to discount FCFF generates appropriately the total value of all of the firm’s capital. The equity value can be calculated as: Equity value = firm value – the market value of debt.
The value of equity is found by discounting FCFE at the required rate of return on equity (r):
Equity value = FCFE / [(1+r)^t]
As FCFE is the cash flow remaining for equity holder post satisfaction of other claims, discounting FCFE by r (the required rate of return on equity) gives the value of the firm’s equity.
As opposed to dividends, data for FCFF and FCFE are not easily available. Hence, forecasting future free cash flows is a rich and demanding exercise. As free cash flows provide a sound basis for evaluation, it is often considered that free cash flow models are more useful than DDM models, in practice.