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2021 Curriculum CFA Program Level II Equity Investments

Free Cash Flow Valuation

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Introduction

Discounted cash flow (DCF) valuation views 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). Our coverage extends DCF analysis to value a company and its equity securities by valuing free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). Whereas dividends are the cash flows actually paid to stockholders, free cash flows are the cash flows available for distribution to shareholders.

Unlike dividends, FCFF and FCFE are not readily available data. Analysts need to compute these quantities from available financial information, which requires a clear understanding of 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’s understanding 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 analysts consider free cash flow models to be more useful than DDMs in practice. Free cash flows 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, and 86.9% use a discounted free cash flow model. Of those using discounted free cash flow models, FCFF models are used roughly twice as frequently as FCFE models. Analysts often use more than one method to value equities, and it is clear that free cash flow analysis is in near universal use.

Analysts like to use free cash flow as the return (either FCFF or FCFE) whenever one or 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 indirectly by first using an FCFF model to estimate the value of the firm and then subtracting the value of non-common-stock capital (usually debt) to arrive at an estimate of the value of equity. The purpose of the coverage in the subsequent sections is to develop the 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 free cash flow to equity and then present the two valuation models based on discounting of FCFF and FCFE. We also explore the constant-growth models for valuing FCFF and FCFE, which are special cases of the general models. The subsequent sections turn to the vital task of calculating and forecasting FCFF and FCFE. They also explain multistage free cash flow valuation models and present some of the issues associated with their application. Analysts usually value operating assets and non-operating assets separately and then combine them to find the total value of the firm, an approach described in the last section on this topic.

Learning Outcomes

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;

  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.

Summary

Discounted cash flow models are widely used by analysts to value companies.

  • Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are the cash flows available to, respectively, all of the investors in the company and to common stockholders.

  • Analysts like to use free cash flow (either FCFF or FCFE) as the return

    • if the company is not paying dividends;

    • if the company pays dividends but the dividends paid differ significantly from the company’s capacity to pay dividends;

    • if free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable; or

    • if the investor takes a control perspective.

  • The 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 = t = 1 FCFF t ( 1 + WACC ) t .

    The value of equity is the value of the firm minus the value of the firm’s debt:

    Equity value = Firm value – Market value of debt.

    Dividing the total value of equity by the number of outstanding shares gives the value per share.

    The WACC formula is

    WACC = MV ( Debt ) MV ( Debt ) + MV ( Equity ) r d ( 1 Tax rate ) + MV(Equity) MV ( Debt ) + MV ( Equity ) r .

  • The value of the firm if FCFF is growing at a constant rate is

    Firm value = FCFF 1 WACC g = FCFF 0 ( 1 + g ) WACC g .

  • With the FCFE valuation approach, the value of equity can be found by discounting FCFE at the required rate of return on equity, r:

    Equity value = t = 1 FCFE t ( 1 + r ) t .

    Dividing the total value of equity by the number of outstanding shares gives the value per share.

  • The value of equity if FCFE is growing at a constant rate is

    Equity value = FCFE 1 r g = FCFE 0 ( 1 + g ) r g .

  • FCFF and FCFE are frequently calculated by starting with net income:

    FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv.

    FCFE = NI + NCC – FCInv – WCInv + Net borrowing.

  • FCFF and FCFE are related to each other as follows:

    FCFE = FCFF – Int(1 – Tax rate) + Net borrowing.

  • FCFF and FCFE can be calculated by starting from cash flow from operations:

    FCFF = CFO + Int(1 – Tax rate) – FCInv.

    FCFE = CFO – FCInv + Net borrowing.

  • FCFF can also be calculated from EBIT or EBITDA:

    FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv.

    FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv.

    FCFE can then be found by using FCFE = FCFF – Int(1 – Tax rate) + Net borrowing.

  • Finding CFO, FCFF, and FCFE may require careful interpretation of corporate financial statements. In some cases, the necessary information may not be transparent.

  • Earnings components such as net income, EBIT, EBITDA, and CFO should not be used as cash flow measures to value a firm. These earnings components either double-count or ignore parts of the cash flow stream.

  • FCFF or FCFE valuation expressions can be easily adapted to accommodate complicated capital structures, such as those that include preferred stock.

  • A general expression for the two-stage FCFF valuation model is

    Firm value = t = 1 n FCFF t ( 1 + WACC ) t + FCFF n + 1 ( WACC g ) 1 ( 1 + WACC ) n .

  • A general expression for the two-stage FCFE valuation model is

    Equity value = t = 1 n FCFE t ( 1 + r ) t + ( FCFE n + 1 r g ) [ 1 ( 1 + r ) n ] .

  • One common two-stage model assumes a constant growth rate in each stage, and a second common model assumes declining growth in Stage 1 followed by a long-run sustainable growth rate in Stage 2.

  • To forecast FCFF and FCFE, analysts build a variety of models of varying complexity. A common approach is to forecast sales, with profitability, investments, and financing derived from changes in sales.

  • Three-stage models are often considered to be good approximations for cash flow streams that, in reality, fluctuate from year to year.

  • Non-operating assets, such as excess cash and marketable securities, noncurrent investment securities, and nonperforming assets, are usually segregated from the company’s operating assets. They are valued separately and then added to the value of the company’s operating assets to find total firm value.