Free Cash Flow Valuation (2024)

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Introduction

Discounted cash flow (DCF) valuation views the intrinsic value of a security as thepresent value of its expected future cash flows. When applied to dividends, the DCFmodel is the discounted dividend approach or dividend discount model (DDM). Our coverageextends DCF analysis to value a company and its equity securities by valuing freecash flow to the firm (FCFF) and free cash flow to equity (FCFE). Whereas dividendsare the cash flows actually paid to stockholders, free cash flows are the cash flowsavailable for distribution to shareholders.

Unlike dividends, FCFF and FCFE are not readily available data. Analysts need to computethese quantities from available financial information, which requires a clear understandingof free cash flows and the ability to interpret and use the information correctly.Forecasting future free cash flows is a rich and demanding exercise. The analyst’sunderstanding of a company’s financial statements, its operations, its financing,and its industry can pay real “dividends” as he or she addresses that task. Many analystsconsider free cash flow models to be more useful than DDMs in practice. Free cashflows provide an economically sound basis for valuation.

A study of professional analysts substantiates the importance of free cash flow valuation(Pinto, Robinson, Stowe 2019). When valuing individual equities, 92.8% of analysts use market multiples and 78.8%use a discounted cash flow approach. When using discounted cash flow analysis, 20.5%of analysts use a residual income approach, 35.1% use a dividend discount model, and86.9% use a discounted free cash flow model. Of those using discounted free cash flowmodels, FCFF models are used roughly twice as frequently as FCFE models. Analystsoften use more than one method to value equities, and it is clear that free cash flowanalysis is in near universal use.

Analysts like to use free cash flow as the return (either FCFF or FCFE) whenever oneor more of the following conditions is present:

• The company does not pay dividends.

• The company pays dividends, but the dividends paid differ significantly from the company’s capacity to pay dividends.

• Free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable.

• The investor takes a “control” perspective. With control comes discretion over the uses of free cash flow. If an investor can take control of the company (or expects another investor to do so), dividends may be changed substantially; for example, they may be set at a level approximating the company’s capacity to pay dividends. Such an investor can also apply free cash flows to uses such as servicing the debt incurred in an acquisition.

Common equity can be valued directly by finding the present value of FCFE or indirectlyby first using an FCFF model to estimate the value of the firm and then subtractingthe value of non-common-stock capital (usually debt) to arrive at an estimate of thevalue of equity. The purpose of the coverage in the subsequent sections is to developthe background required to use the FCFF or FCFE approaches to value a company’s equity.

In the next section, we define the concepts of free cash flow to the firm and freecash flow to equity and then present the two valuation models based on discountingof FCFF and FCFE. We also explore the constant-growth models for valuing FCFF andFCFE, which are special cases of the general models. The subsequent sections turnto the vital task of calculating and forecasting FCFF and FCFE. They also explainmultistage free cash flow valuation models and present some of the issues associatedwith their application. Analysts usually value operating assets and non-operatingassets separately and then combine them to find the total value of the firm, an approachdescribed in the last section on this topic.

The member should be able to:

1. compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation;

2. explain the ownership perspective implicit in the FCFE approach;

3. explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE;

   See Also

   The Importance of Cash Flow and the EBITDA Limitation - GHJBrian Feroldi on LinkedIn: EBITDA Vs FCF What's the difference? EBTIDA = EARNINGS BEFORE INTEREST… | 55 commentsFree Cash Flow Defined & Calculated | The Motley Fool

4. calculate FCFF and FCFE;

5. describe approaches for forecasting FCFF and FCFE;

6. compare the FCFE model and dividend discount models;

7. explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE;

8. evaluate the use of net income and EBITDA as proxies for cash flow in valuation;

9. explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models and select and justify the appropriate model given a company’s characteristics;

10. estimate a company’s value using the appropriate free cash flow model(s);

11. explain the use of sensitivity analysis in FCFF and FCFE valuations;

12. describe approaches for calculating the terminal value in a multistage valuation model; and

13. evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash flow valuation model.