![]() ![]() ![]() An alternate way of describing free cash flow to the firm is that it measures the cash flows that would have been available for equity investors, if there were no debt in the firm, and it is for this reason that some call it an unlevered cash flow. Since a business can raise capital from owners (equity) and lenders (debt), the FCF that you compute can be to just the equity investors in the business, in which case it is FCFE, or to all capital providers in the business, as FCFF.įCFE is the cash flow that a business generates after taxes, reinvestment and debt payments (interest and principal).įCFF is a pre-debt cash flow, before interest payments and debt repayments or issuances, but still after taxes and reinvestment. ![]() I have also seen FCF measures stretched to cover adjusted EBITDA, where stock-based compensation is added back to EBITDA.Īny measurement of FCF has to begin with a definition of to whom those cash flows accrue. I have seen analysts and managers argue that adding back depreciation to earnings gives you FCF, an intermediate stop, at best, if you truly are intent on computing FCF. While I understand that there is no one overriding definition of cash flow that trumps others, it is essential that we define what we mean when we talk about free cash flow.įCF is one of the most dangerous terms in finance, and I am astonished by how it can be bent to mean whatever investors or managers want it to, and used to advance their sales pitches. I am someone who believes that intrinsic value comes from expected cash flows. Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA)Īswath Damodaran, professor of finance at the Stern School of Business, New York University, explains:.While net income is used to measure profitability, Free Cash Flow provides insights into a company’s business model and financial health. It tells you how much cash a company is generating after paying the costs to remain in business. This is the cash that can be paid to shareholders after paying for all expenses, debt repayments, and reinvestments. Free Cash Flows to Equity are available to stock holders only return of these cash flows to stock investors does not threaten the company’s existence as a going concern.Free Cash Flow is the cash that remains after a company pays to support its operations and capital expenditure. This includes debt obligations, capital expenditure to maintain existing assets, and new asset purchases to maintain the growth rate assumed. One can easily extract the information required to value a firm using FCFF from the company’s financial statements.įCFF can also be calculated using Cash Flow from Operations as follows:įCFF from Cash Flow from Operations = Cash Flow from Operations – Fixed Capital Investment + Interest expense * (1 – tax)įCFE is defined as the amount of free cash flow the firm has after meeting all its obligations. FCFF is also suitable for firms that have a tendency to frequently change their degree of financial leverage.įCFF can be calculated from Net Income using the following formula:įCFF from Net Income = Net Income + Non-cash Charges + (Interest Expense * (1-tax rate)) – Fixed Capital Investment – Working Capital Investment We can then deduct the value of debt to arrive at the value of equity alone.įCFF valuation is more suitable compared to FCFE when the company has high leverage, and/or negative FCFE. The value we arrive at will represent the value of the entire firm. The two new cash flow measures used to value a firm are Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE).įCFF represents the free cash flow available to both equity and debt holders, while FCFE represents free cash flow available for only equity holders.Ī firm can be valued by estimating the Free Cash Flow to Firm and discounting them by the Weighted Average Cost of Capital (WACC). However, the problem with dividends is that it does not fully reflect the cash flow earned by the firm. Traditionally, analysts have used dividends as the proxy for cash flows, hence the dividend discount model. Under this model, an analyst will estimate the future cash flows for the company, and discount it with the appropriate discount rate. The discounted cash flow model is the most advocated model for valuing a stock. ![]()
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