Free Cash Flow Method (FCF): Meaning and Components

In the previous chapter, we understood how to apply the discounted cash flow [DCF] method to find the intrinsic value of a company’s equity share. To brush up on the concept, the DCF method aims to discount the expected cash flows from a company to their present value. These cash flows can be in the form of:

• Dividends 
• Free cash flows

In the previous chapter of the dividend discounted model, we learned how to discount future expected dividends to determine the intrinsic value. 

This chapter will focus on the alternative method to the dividend discount model, i.e., the free cash flow method  [FCFF method].

Please note that both methods may not yield the same intrinsic value of a share, which is fine. As mentioned in the earlier chapters, these models are based on many assumptions so the answers might vary. However, it is also advantageous to investors as they get a range of intrinsic value for a share using a variety of methodologies.

Free Cash Flow to the Firm

What are free cash flows? Simply put, free cash flow is the cash flow that is available to the firm after meeting its capital expenditure needs. This cash flow is ultimately available for distribution to equity and debt holders. And that’s why it can be used to determine the firm's value. Also, the FCFF method to value a company is suitable where the dividend discount model cannot be used due to the company's inability to distribute dividends. 

The underlying principle to find the company's intrinsic value is the same as the dividend discount model to the extent that both use the present value of the future expected cash flows to find the value of a company. 

It is just that under the free cash flow method, expected free cash flow is discounted to determine the firm's value instead of dividends.

Free cash flows to the firm = Cash flow from operations + Interest ( 1 - Tax rate ) - Net capital expenditure

Let’s understand the components individually:

1. Cash flow from operations: We already understood CFOs in the cash flow statement chapter. Simply put, the CFO is the cash generated from the principal business operations of the company. For more details, refer to that chapter. 
2. Interest: This is simply the cost of debt for the company. This is added because as mentioned earlier, FCFF is the cash flow to the whole firm, including debtholders and equityholders. Also, please note that after-tax interest costs are taken as interest is a tax-deductible expense. 
3. Capital expenditure: As the name suggests, this includes all the firm's net expenditures to build non-current assets. This may include expenditure to buy, maintain, or upgrade land, property plant and machinery, etc. as well as receivables from the sale of the above-mentioned assets. The net figure i.e. net of receipts and sales, is taken to calculate net fixed capital expenditure. 

Let's calculate the free cash flows for XYZ Ltd:

• Cash flow from operations can directly be taken from the cash flow statement 
• Finance cost given in the statement of profit & loss can be taken for interest cost
• The tax rate can be readily available in the annual report of the company 
• Capex figures are directly provided in the annual report of the company 

Example: 

Remember to deduct the sale of non-current assets to arrive at the net capex figure to be used in the FCFF calculation 

All the above information is readily available in the company's annual report. Let’s put them into a tabular format. 

After incorporating the same, the FCFF figure for XYZ Ltd. is ₹1,061.4 crore

This is the ultimate free cash flow available to the firm for distribution to debt and equity holders. 

Forecasting of FCFFs

Like dividends, free cash flows must be forecasted for future periods and discounted to determine the firm’s value. 

Of course, the growth rate will be an assumption, and the past growth rate can be a great estimator for forecasting the future growth rate. 

The last 5 years' data for FCFF and the historical growth rate information for XYZ Ltd. is as follows:

The average growth rate of 5 years turned out to be 4.96% or 5% approx. 

Gordon growth model for FCFF 

Like the dividend discount model, the Gordon or constant growth model can be used to calculate the firm's value using the FCFF approach. 

Gordon growth model for FCFF: 

Value of the firm = FCFF1 / (WACC - G)

Where,

FCFF1 = Forecasted FCFF next year 

WACC = Weighted average cost of capital 

G = Growth rate of FCFF 

In this formula, FCFF and G factors are clear to us. But what is this WACC? Let us understand this:

Weighted average cost of capital 

In the dividend discount model, we saw how dividends are discounted at the required rate of return [Ke] to arrive at the intrinsic value of a share. However, as we saw that FCFF is a cash flow measure to the whole firm and not just equity, we need a much broader discount rate as our required rate of return on capital. That’s where the weighted average cost of capital comes into the picture [WACC]. 

From the name itself, we can determine that WACC is the average rate of return the company has to pay its shareholders and equity holders. It is the weighted average of returns to debt and equity holders, with weights being the proportion of debt and equity used in total capital. 

WACC = WEquity * Ke + WDebt * Kd ( 1 - Tax rate )

Where, 

WEquity  = Weighatge of equity in total capital 

Ke = Required rate of return on equity 

WDebt = Weighatge of debt in total capital

Kd = Required rate of return on debt 

Let’s calculate WACC for XYZ Ltd. 

The weight of debt and equity can be computed using the proportion of debt and equity used in the total capital. As seen in the solvency chapter, the debt-to-equity ratio for XYZ Ltd was .105. This means the weightage of debt in total capital is:

= 0.105 / (1+0.105)

= 0.09

Therefore the weightage of equity is

= 1 - the weight of debt 

= 1 - 0.09

=0.91

The required rate of return on equity is 12.48%, computed in the previous chapter using the Capital asset pricing model [CAPM]. 

The required return on debt is the interest rate that the company pays on its long-term debt. It will vary from company to company and can be easily found in its annual report. Let it be 8% for XYZ Ltd.

Therefore WACC for XYZ Ltd 

= 0.91 * (12.48%) + 0.09 * (8%) ( 1 - 25% )

= 11.357% + 0.54% 

= 11.897%

Now the value of the firm using the Gordon growth FCFF model is

Value of the firm = FCFF1 / (WACC - G)

= 1061 * 1.05 / ( 11.897% - 5% )

= 1114.05 / 6.897%

= ₹12,809.58 crore 

This is the value of the entire firm. Now please note we need to make two last adjustments to arrive at the intrinsic value of equity

Value of equity = Value of firm - Value of debt + Cash and cash equivalent

= 12,809.58 - 998 + 325.92

= ₹12,137.5 crore

This is the firm's total equity value arrived at using the FCFF approach. Divide this by the total number of shares to arrive at the intrinsic value 

The total number of shares given in the balance sheet is 48 crore. 

Intrinsic value of XYZ Ltd = 12,137 / 48 

= ₹252.85  

What If the FCFF Does Not Grow at a Constant Rate?

Similar to the multi-stage dividend discount model, if the FCFF does not grow constantly, an investor wants to make certain assumptions regarding the FCFF growth rate in the initial years until it stabilizes at a long-term growth rate, it can be incorporated into the formula. 

Suppose an investor thinks the FCFF growth rate for XYZ Ltd will be:

Year 1 = 8%

Year 2 = 7%

Year 3 = 6%

And then after year 3, it will stabilise at a long-term average rate of 5%. Then the value of the firm will be calculated as:

FCFF 1 / (1 + WACC ) 1 + FCFF 2 / (1 + WACC ) 2 + (FCFF 3 + TV) / (1 + WACC ) 3

Where

TV = Terminal value of the firm at the end of year 3 

FCFF 1 = 1061* 1.08

= 1145.88

FCFF 2 = 1061* 1.08 * 1.07

= 1226.09

FCFF 3 = 1061* 1.08 * 1.07 * 1.06 

= 1299.66 

TV at the end of year 3 

= FCFF 3 * ( 1 + G ) / ( WACC - G )

= 1364.64 / 6.897%

= 19,785.99 

Value of the firm:

= 1145.88 / (1.11897)1 + 1226.09 / (1.11897)2 + (1299.66 + 19,785.99)  / (1.11897)3 

= ₹17,053.11 crore 

Value of equity = Value of firm - Value of debt + Cash and cash equivalent

= 17,053.11 - 998 + 325.92

= ₹16,381.03 crore

The last step is to divide this value of equity by the number of shares

= 16,381.03 / 48 

= ₹341.27 

You see, by simply changing the assumption, there is a significant change in the intrinsic value of XYZ Ltd’s share. The value increased significantly because the growth rates were higher for the initial 3 years.  

However, the decision rule stays the same i.e.:

If Intrinsic value > Market price, the stock is undervalued 
If intrinsic value < Market price, the stock is overvalued 
If intrinsic value = Market price, the stock is fairly valued. 

You might have seen that the methodology used to calculate the intrinsic value is similar to the dividend discount model and the free cash flow method. That’s why in this chapter, we focused more on defining free cash flows and how to calculate it. The rest of the process of calculating the intrinsic value is similar to that of the dividend discount model. And it has to be similar because, ultimately both the methods are part of present value methods. 

Notable differences between the dividend discount model and the FCFF model to value share of a company are:

The FCFF model uses free cash flows as a measure of cash flows, unlike the dividend discount model, which uses dividends. 
The discount rate used in the FCFF model is the weighted average cost of capital, unlike the dividend discount model, which uses the required rate of return (ke). 
FCFF discounting at the WACC rate leads to the calculation of the firm's value, not equity value. Value of debt is subtracted and cash and cash equivalents are added to arrive at the equity value. Unlike the dividend discount model, which directly helps in calculating equity value. 

The FCFF model has limitations:

Many assumptions are used to determine the firm's value. 
The model is very sensitive to the inputs. Even a small change in the inputs to the model can lead to a drastic change in the value of the firm estimates. 
If the company is growing or expanding aggressively, net capital expenditure could be more than the cash flow from operations, leading to negative free cash flows. In that case, the FCFF model cannot be used. 

This summarises our discussion on the discounted cash flow approach to value a company. In the next chapter, we will focus on our second approach to valuation, i.e. relative valuation.