Free Cash Flow

Free cash flow is the amount of cash generated by a business that is available for distribution among its security holders. Security holders include debt holders, equity holders, preferred stock holders, and convertible security holders.

Specifically, free cash flow is used to pay dividends, make acquisitions, develop new products, invest in new property, plant and equipment, pay interest expenses, and reduce debt.

Types

There are two types of most commonly used free cash flow: free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).

Free cash flow to the firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital (e.g., inventory) and fixed capital (e.g., equipment) have been made. FCFF is the cash flow from operations minus capital expenditures. A company’s suppliers of capital include common stockholders, bondholders, and sometimes, preferred stockholders. The equations analysts use to calculate FCFF depend on the accounting information available.

Free cash flow to equity is the cash flow available to the company’s holders of common equity after all operating expenses, interest, and principal payments have been paid and necessary investments in working and fixed capital have been made. FCFE is the cash flow from operations minus capital expenditures minus payments to (and plus receipts from) debtholders.

When to Use

Free Cash Flow Analysis is one type of discounted cash flow analysis. 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.

How to Use

The way in which free cash flow is related to a company’s net income, cash flow from operations, and measures such as EBITDA (earnings before interest, taxes, depreciation, and amortization) is important: The analyst must understand the relationship between a company’s reported accounting data and free cash flow in order to forecast free cash flow and its expected growth. Although a company reports cash flow from operations (CFO) on the statement of cash flows, CFO is not free cash flow. Net income and CFO data can be used, however, in determining a company’s free cash flow.

The advantage of FCFF and FCFE over other cash-flow concepts is that they can be used directly in a DCF framework to value the firm or to value equity. Other cash-flow- or earnings-related measures, such as CFO, net income, EBIT, and EBITDA, do not have this property because they either double-count or omit cash flows in some way. For example, EBIT and EBITDA are before-tax measures, and the cash flows available to investors (in the firm or in the equity of the firm) must be after tax. From the stockholders’ perspective, EBITDA and similar measures do not account for differing capital structures (the after-tax interest expenses or preferred dividends) or for the funds that bondholders supply to finance investments in operating assets. Moreover, these measures do not account for the reinvestment of cash flows that the company makes in capital assets and working capital to maintain or maximize the long-run value of the firm.

Using free cash flow in valuation is more challenging than using dividends because in forecasting free cash flow, the analyst must integrate the cash flows from the company’s operations with those from its investing and financing activities. Because FCFF is the after-tax cash flow going to all suppliers of capital to the firm, the value of the firm is estimated by discounting FCFF at the weighted average cost of capital (WACC). An estimate of the value of equity is then found by subtracting the value of debt from the estimated value of the firm. The value of equity can also be estimated directly by discounting FCFE at the required rate of return for equity (because FCFE is the cash flow going to common stockholders, the required rate of return on equity is the appropriate risk-adjusted rate for discounting FCFE).

The two free cash flow approaches, indirect and direct, for valuing equity should theoretically yield the same estimates if all inputs reflect identical assumptions. An analyst may prefer to use one approach rather than the other, however, because of the characteristics of the company being valued. For example, if the company’s capital structure is relatively stable, using FCFE to value equity is more direct and simpler than using FCFF. The FCFF model is often chosen, however, in two other cases:

  • A levered company with negative FCFE. In this case, working with FCFF to value the company’s equity might be easiest. The analyst would discount FCFF to find the present value of operating assets (adding the value of excess cash and marketable securities and of any other significant nonoperating assets1 to get total firm value) and then subtract the market value of debt to obtain an estimate of the intrinsic value of equity.

  • A levered company with a changing capital structure. First, if historical data are used to forecast free cash flow growth rates, FCFF growth might reflect fundamentals more clearly than does FCFE growth, which reflects fluctuating amounts of net borrowing. Second, in a forward-looking context, the required return on equity might be expected to be more sensitive to changes in financial leverage than changes in the WACC, making the use of a constant discount rate difficult to justify.

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