Free Cash Flow to Firm Valuation

fcff-vizQuick Summary
1. Calculate historical free cash flow to firm from accounting data
2. Estimate the short-term growth rate
3. Estimate the long-term, sustainable growth rate
4. Project how long the initial period of high growth will last before transitioning to the final stable growth phase
5. Forecast future free cash flows to firm
6. Determine the firm value by discounting future cash flows to present at WACC and subtracting debt

1. Historical Free Cash Flow to Firm
The free cash flow to firm (FCFF) approach to valuing a firm has the advantage over the dividend discount model in that it measures the cash flows available to shareholders rather than solely the cash flows actually paid. FCFF is preferred in cases when a firm has recently changed or is in the process of changing its leverage. While cash flows relating to debt need to be explicitly considered in estimating FCFE, they do not with the FCFF approach.

Computing FCFF from historical accounting data is relatively straightforward.

FCFF = Net income + Net noncash charges + Interest expense (1 – Tax rate) – Investment in fixed capital – Investment in working capital

Another common way to express free cash flow to firm is as follows.

FCFF = EBIT (1 – Tax rate) + Depreciation – Capital Expenditure – Δ Working Capital

The most common noncash charges are depreciation and amortization. However, they can also include restructuring charges, gains and losses, deferred taxes, and stock options. Refer to the company’s statement of cash flows to find historical noncash charges. Deferred tax liabilities (assets) should only be added (subtracted) if the charges are expected to persist on a continual basis (i.e. not reverse in the near future). The tax rate is the marginal corporate income tax rate.

Investments in fixed capital represents expenditures on long-term assets, such as PP&E. They may also include intangible assets, such as trademarks. Cash acquisitions of other companies can be treated as capital expenditures, preferably averaged over several years. Analysts should consult the company’s footnotes to identify any assets acquired in exchange for stock. While this would not affect historical cash flows, the information could be useful in forecasting future FCFF. Any cash received from the disposal of fixed assets should be ignored.

Working capital is defined as current assets minus current liabilities. For valuation purposes, cash and cash equivalents as well as short-term debt (including notes payable and the current portion of long-term debt) should be excluded. For the few companies that have preferred stock dividends, this item should be added back to FCFF since it was deducted in arriving at net income.

2. Short-term Growth Rate
The expected short-term growth rate of FCFF is estimated as the product of the firm reinvestment rate (here) and the return on invested capital (here). Industry averages may provide a good indication of future reinvestment rates since reinvestment needs tend to decrease as firms grow and mature. To ensure the return on capital estimate is forward looking, review historical trends in ROC, industry averages, and the marginal return on assets.

FCFF short-term growth

If a company’s FCFF has grown at a constant rate and if the historical trend is expected to continue, then the historical growth rate may also be appropriate. Note that the growth rate in a FCFF model is frequently not the same as the growth rate for sales, net income, or FCFE. If FCFF is forecasted by its individual components rather than in aggregate, make sure that capital expenditures are internally consistent with the growth assumption by referring to the firm reinvestment rate formula.

3. Long-term Growth Rate
The long-term sustainable growth rate of a firm can be estimated as a function of the firm reinvestment rate and return on capital. However, the revised inputs should reflect the trends of mature industry peers in steady state. There are also real constraints on how high the stable growth rate can be. The long-run growth rate of a firm cannot be greater than the growth rate of the overall economy. If the company operates domestically, the growth rate cannot be in excess of the domestic economy. If the firm operates (or will operate) multi-nationally, the growth rate cannot be in excess of the global economy (or the weighted average of the economies that the firm operates in).

Since the Treasury bond rate converges on the growth rate of the economy in the long term, another simple rule of thumb is to keep the sustainable growth rate less than or equal to the riskless rate. The most likely scenario is that as firms mature they will have a growth rate lower than that of the economy. Be aware that firms may already be in a steady state.

4. Transition Phase
Estimating how abruptly or gradually the initial high growth rate will converge to the stable growth rate depends on a firm’s size, current growth rate, and its competitive advantages. Firms with moderate advantages might preserve their high growth rate for 5 years while firms with strong advantages might maintain them for 10 years. Firms with very high growth rates will likely see their growth drop suddenly in the first two years and then gradually thereafter.

Constant growth models are used for firms already in stable growth. Two-stage models (high growth rate changing abruptly to stable growth) are best suited for companies where the initial growth rate is already very close to the stable growth rate. Three-stage models (high growth for a period and then gradually converges to stable growth levels) are good for companies with very high growth rates that will have a transition phase. N-stage models work best for firms that are young and expect changes in each year.

As firms transition from high growth to stable growth, their risk characteristics should be similar to other mature firms. Stable firms, for example, should have a beta close to one (between 0.8 and 1.2) and use greater debt. The change in financial leverage can be estimated by referring to the target capital structure indicated by management or the average debt ratio among more mature firms in the industry. Be sure to re-estimate the synthetic credit rating and cost of debt for the firm into the future to check for internal consistency (here).

5. Forecasting Free Cash Flows to Firm 
There are three main approaches to forecasting future FCFF. The simplest method is to extrapolate FCFF in aggregate based on historical trends. The second and most common approach is to forecast the individual components of FCFF. EBIT can be forecasted directly or by forecasting sales and the company’s EBIT margin. Incremental investments in fixed capital and working capital are then estimated as a proportion of sales. Incremental fixed capital expenditures are calculated as capital expenditures minus depreciation expense. (This simplification of FCFF assumes depreciation is the only noncash charge). This model of forecasting allows varying sales growth rates, EBIT margins, tax rates, and rates of incremental capital increases. The third and most granular approach would be to explicitly forecast the financial statements (here) over a certain time horizon.

In determining after-tax EBIT, the effective tax rate should be used in the current period but slowly converge with the marginal tax rate over time. Note that the tax rate chosen in valuing a firm should be the same rate used when calculating the after-tax cost of debt in the WACC computation. Since firm valuations are highly responsive to input variables, analysts should conduct a sensitivity analysis.

If FCFF is forecasted in aggregate (as opposed to by its constituent parts), it is crucial to normalize the base-year value. Capital expenditures, including acquisitions, should be smoothed out to correct for year-to-year jumps by taking the average over three to five years. Depreciation should remain the current year amount.

6. Discount Free Cash Flows to Equity at the WACC
Since FCFF is the after-tax cash flows going to all suppliers of capital to the firm, the value is estimated by discounting FCFF at the WACC. Below is the expression for a multi-stage FCFF valuation model. The last term is a constant growth formula to estimate the terminal value. Common equity can be valued by determining firm value and then adding back cash and cash equivalents and subtracting debt (including the capitalized amount of operating leases and preferred stock).

FCFF Valuation

This formula assumes all cash flows occur at year-end. Firm value can be adjusted to incorporate the fact that most cash flows occur throughout the year by multiplying the prior sum by (1 + WACC)^0.5.

If a mature firm is believed to already operate in a steady state and growth is expected to remain constant, the following single-stage model can be used to value the firm.

FCFF Firm Value

To determine the equity value per share, subtract the current market value of non-equity capital (usually debt) and divide by the number of shares outstanding. Given the dilutive effect that employee stock options can have on equity, a better estimate can be obtained by adding any fully vested and in-the-money stock options to the denominator.

Aswath Damodaran has a helpful FCFF valuation presented in a concise picture within Investment Valuation. My own Excel replica (with modification) is attached under Suggested Reading.

Concluding Thoughts
If a company has significant non-operating assets (liabilities), they should be valued separately and added (subtracted) from the FCFF valuation. Common non-operating assets include holdings in other firms, unutilized assets (e.g. land), overfunded pension funds, and tax loss carryforwards. Frequently encountered non-operating liabilities include unfunded pension obligations, contingent liabilities, minority interests, and deferred tax liabilities. There are separate posts on this blog for valuing non-operating assets (here) and non-operating liabilities (here).

It is important to be aware that vendor-supplied databases of financial information may use alternative definitions of FCFF than the one provided here. These are not designed for valuation purposes and can increase the likelihood of errors if used for valuation. Analysts should always understand exactly how FCFF numbers are calculated that are supplied by others.

An appropriate alternative FCFF definition is calculated by examining the uses of free cash flow to firm as opposed to its sources. This serves as a useful consistency check and may better illuminate a company’s capital structure or cash position. Uses of FCFF include (1) increases (or minus decreases) in cash balances, (2) net payments to providers of debt capital, and (3) payments to providers of equity capital.

FCFF = ΔCash and cash equivalents + Interest expense (1 – Tax rate) + Repayment of debt principal – New debt borrowing + Cash dividends + Share repurchases – New share issuance

Suggested Reading
Aswath Damodaran. Firm Valuation.

FCFF Visualization in Excel.

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