How to predict and evaluate stock using 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

Interpretation how-to-predict-and-evaluate-stock-using

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)