Predicting and evaluating stock using the FCFF Model
Analysts utilize the five most widely used models comprising stock valuation formulas for stock valuation.
FCFF and FCFE, unlike dividends, do not have widely available data. Analysts must compute these amounts from accessible financial information, which necessitates a thorough grasp of free cash flows as well as the ability to appropriately interpret and use the data. Forecasting future free cash flows is likewise a rich and difficult task. Understanding a company’s financial statements, operations, funding, and industry may yield actual “dividends” while the analyst works on that assignment. In practice, many analysts believe that free cash flow models are more useful than DDMs. Free cash flows provide an economically sound foundation for value creation. When one or more of the following conditions exist, analysts prefer to utilize free cash flow as the return (either FCFF or FCFE).
• Dividends are not paid by the firm.
• The company pays dividends, but the amount paid differs significantly from the company’s ability to pay dividends.
• The analyst is comfortable with a reasonable forecast horizon for free cash flows and profitability.
• The investor adopts a “control” mindset. With control comes the ability to choose how to spend free cash flow. If an investor has the ability to seize control of the firm (or expects another investor to do so), dividends may be significantly altered; for example, they may be set at a level that approximates the company’s ability to pay dividends. An investor of this type can also put free cash flows to good use, such as repaying debt committed after an acquisition.
How to calculate free cash flow to the firm (FCFF)
All operational expenditures (including taxes) and essential investments in working capital (e.g., inventory) and fixed capital (e.g., equipment) have been covered by the company’s free cash flow. Operational cash flow after deducting capital expenditures (FCFF). As a result, investments have been made in working and fixed capital. FFCE is the difference between the cash flow from operations and capital expenditures, as well as the payments to and receipts from debtholders. Common shareholders, bondholders, and, in some cases, preferred stockholders are all sources of money for a firm. The formulae used by analysts to compute FCFF are determined by the accounting information provided. The cash flow available to the company’s common stockholders after all operating expenditures, interest, and principal payments have been paid and essential investments in working and fixed capital have been made is referred to as free cash flow to equity. FCFE is defined as cash flow from operations minus capital expenditures minus debtholder payments (and plus revenues from) debtholders.
There are several ways to calculate FCFF & FCFE. In the next part, we’ll go through each technique one by one.
Plus: Net income available to common shareholders (NI)
Plus: Net noncash charges (NCC)
Plus: After-Tax interest expense (1 – Tax rate)
less: Investment in fixed capital (FC)
less: Investment in working capital (WC)
FCFF = NI + NCC + Int (1 − Tax rate) − FC– WC
Net income is defined as income after depreciation, amortization, interest expenditure, income taxes, and dividends paid to preferred shareholders (but not payment of dividends to common shareholders).
Depreciation expenditure is the most frequent noncash item. When a business buys fixed capital, such as equipment, the balance sheet shows a cash outflow at the moment of acquisition. Depreciation expenditure is recorded in succeeding quarters as the asset is utilized. Depreciation decreases net income but does not result in a cash outflow. Thus, depreciation expenditure is one (among the most prevalent) noncash charge that must be brought back in when calculating FCFF. A comparable noncash charge, amortization expenditure, must be added back in the case of intangible assets.
FCFF is calculated by adding back after-tax interest expenditure to net income. This step is necessary since interest expenditure was subtracted from net income after deducting associated tax savings, and interest represents a cash flow accessible to one of the company’s capital suppliers (i.e., the company’s debtors). Interest is tax deductible (reduces taxes) for the firm (borrower) but taxable for the receiver in many nations (lender). When we discount FCFF, we utilize an after-tax cost of capital, as we will explain later.
If a business has preferred stock, dividends on that preferred stock are deducted in the same way as after-tax interest cost is when calculating net income accessible to common shareholders. Because preferred stock dividends represent a cash flow accessible to one of the company’s capital sources, they are added back to net income available to common shareholders for calculating FCFF.
Fixed capital investments reflect cash expenditures to acquire fixed capital required to sustain the company’s current and future activities. These investments are long-term capital expenditures on assets such as property, plant, and equipment (PP&E) required to sustain the company’s activities. Intangible assets, such as trademarks, may also be considered necessary capital expenditures. In the event of a cash acquisition of another business rather than a direct acquisition of PP&E, the cash purchase price can also be considered a capital expenditure that decreases the company’s free cash flow (note that this treatment is conservative because it reduces FCFF). Analysts must use caution when analysing the impact of big purchases (and any noncash acquisitions) on future free cash flow. If a firm gets cash in exchange for disposing of any of its fixed capital, the analyst must subtract this cash when computing fixed capital investment. For example, say we sold $100,000 in equipment. This cash inflow would lower the company’s cash outflows for fixed capital projects.
Although working capital is sometimes defined as current assets minus current liabilities, for cash flow and valuation reasons, working capital excludes cash and short-term debt (which includes notes payable and the current portion of long-term debt). We define working capital to exclude cash and cash equivalents, as well as notes payable and the current part of long-term debt, when calculating the net increase in working capital for the purpose of computing free cash flow. Cash and cash equivalents are omitted because we are attempting to explain a shift in cash. Notes payable and the current component of long-term debt are omitted since they are liabilities with clear interest charges, making them financing rather than operational items.
When projecting FCFE, analysts frequently assume that the company’s financing includes a “target” debt ratio. In this scenario, they assume that a predetermined proportion of the sum of 1) net new fixed capital investment (new fixed capital less depreciation expenditure) and 2) working capital expansion is financed using a target DR. As a result of this assumption, FCFE calculations are simplified. If depreciation is the sole noncash item, Equation, which is
FCFE = NI + NCC − FCInv − WCInv + Net borrowing, becomes
FCFE = NI − (FCInv − Dep) − WCInv + Net borrowing
It is worth noting that FCInv Dep indicates the incremental fixed capital expenditure minus depreciation. We eliminated the requirement to anticipate net borrowing by assuming a goal DR and can now use the equation
Net borrowing = DR (FCInv − Dep) + DR(WCInv)
We don’t need to anticipate debt issuance and repayment on a yearly basis to estimate net borrowing when we use this phrase. The equation is then transformed into
FCFE = NI − (FCInv − Dep) − WCInv + (DR) (FCInv − Dep) + (DR)(WCInv)