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FINC6600
Presented by
Craig Mellare
University of Sydney Business School
Topic 6A Free Cash Flows in the
Discounted Cash Flows model
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Learning Outcomes
Free Cash Flows (FCFs)
What are FCFs?
FCF Firm and Equity
How are FCFE and FCFF computed?
Leveraging and FCFs
Terminal Value
Defining a forecast horizon
The rate of growth in different parts of the forecast horizon
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Back to Basics the DCF
Intrinsic value of a firm = PV of expected cash flows.
DCF relies on positive cash flows over the life of the asset and
value is determined by the magnitude and timing of cash flows.
Why cash flows?
Why not earnings measures?
( ) ( ) ( ) ( )
n
n
3
3
2
2
1
1
1 r
CF … 1 r
CF
1 r
CF
1 r
CF Value
+
+
+
+
+
+
+ =
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Firm vs. Equity Valuation
Free cash flows (FCF) represent the cash available for distribution to all stakeholders of the
firm.
In other words, operating cash flow less capital expenditures and non cash working capital.
It is the residual cash flow after all expenses necessary to keep the firm growing at its current rate.
Free Cash flow to the Firm (FCFF): is the cash flow available to the companys suppliers of
capital after all operating expenses have been paid and necessary investments in working
capital and fixed capital have been made.
Known as the Invested Capital method
Free Cash flow to Equity (FCFE): is the cash flow available to the companys common equity
holders after all operating expenses have been paid and necessary investments in working
and fixed capital have been made.
Known as the Direct Equity method
FCFE can be calculated by subtracting the value of (usually debt and
preferred stock) from FCFF.
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Free Cash Flow
= Cash flow available to common stockholders
+ Debtholders
+ Preferred stockholders
Free Cash Flow to the Firm
= Cash flow available to common stockholders
Free Cash Flow to Equity
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Free Cash Flow to Equity (FCFE)
FCFE is not a radical departure from the traditional dividend discount model.
The primary difference between models lay in the definition of cash flows.
FCFE = potential dividends paid (depends on firms dividend policy).
DDM = actual/expected dividends paid.
When firms pay dividends FCFE, the values from the two models will be different.
More common that value from FCFE model > DMM model.
Which is more appropriate for valuation?
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Free Cash Flow to Equity (FCFE)
Valuations using FCFE:
Use the Dividend Discount Model (Gordon):
a) For firms which pay dividends (and repurchase stock) which are close to the FCFE (over an extended
period).
b) For firms where FCFE are difficult to estimate (e.g. Banks and Financial Service companies).
Use the FCFE Model:
a) For firms which pay dividends which are significantly higher or lower than the FCFE.
b) For firms where dividends are not available (IPOs, private companies).
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Calculations FCFE (Unlevered Firm)
(1 – T) + DA -WC CAPEX
Since interest expense = 0
FCFEUnlevered Firm = NI + DA WC CAPEX
EBIT: Earnings before interest and taxes
EBIT(1 – T): After-tax operating income or net operating profit after tax (NOPAT)
T: Tax rate
DA: Depreciation and amortisation expense
WC: Change in net working capital
CAPEX: Capital expenditures for property, plant, and equipment
NI: Net Income
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Components of FCFE – Earnings
A companys accounting earnings are not unrelated to its free cash flow.
Earnings are the result of taking the cash flows generated by a firms operating and
investing activities, and accruing or deferring certain cash flows to earlier or later periods.
These accruals and deferrals are designed to facilitate performance evaluation, rather than to
obfuscate the analysis of free cash flow.
To the extent that we start with accounting earnings in a base year, it is worth considering the
following questions:
Are there any one-time charges that might be depressing income in the base year or onetime earnings that might be increasing income in the base year?
Are the earnings negative, and if so, why?
Are there any financial or capital expenses intermingled with operating expenses?
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Components of FCFE Non Cash Charges
Depreciation and Amortisation expense (DA)
Do not represent an actual cash payment
Arises out of the matching principle of accrual accounting, matches expenditures
made for long-lived assets (plant, machinery and equipment) against the
revenues they help generate.
The actual expenditure of cash may have taken place many years earlier when
the assets were acquired.
Other items like Restructuring expense (subtracted out), capital gains (subtracted
out), employee option exercise (added back), deferred taxes (added back).
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Components of FCFE Net Capital Expenditures
(CAPEX)
Net capital expenditures sustain productive capacity and provide for growth firms
invest in long-lived assets
Maintenance CAPEX: Assets physically wear out and need replacement
Growth CAPEX: To achieve growth in future cash flows firms require added
capacity through investments in new PPE and acquisitions of businesses
CAPEX can be calculated by analysing how net PPE on the balance sheet changes
over time
Net property, plant, and equipment is equal to the difference in the
accumulated cost of all property, plant, and equipment (gross PPE) less the
accumulated depreciation for those assets
e.g. CAPEX(2020) = Net PPE (2020) Net PPE(2019) + Depn Expense (2020)
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Components of FCFE Net Capital Expenditures (CAPEX)
In general, net CAPEX will be a function of how fast a firm is growing or expected to
grow.
High growth firms will have much higher net capital expenditures than low growth firms.
Remember product life cycle.
Assumptions about net capital expenditures should NEVER be made independently
of assumptions about growth in the future.
Remember that one-time or unusually high expenditures (perhaps associated with
equipment repairs) should be considered non-recurring for your valuation.
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Components of FCFE Change in Working Capital
In accounting terms, working capital (WC) is the difference between current assets and
current liabilities where:
Current Assets = inventory, cash, accounts receivable
Current Liabilities = short term debt, current portion of long-term debt, accounts
payable
In finance, we use a simpler approach whereby WC is the difference between non-cash
current assets and non-debt current liabilities.
Current Assets = inventory, accounts receivable
Current Liabilities = accounts payable
Any investment in this measure of working capital ties up cash. Therefore, any increase
(decrease) in working capital will reduce (increase) cash flows in that period.
When forecasting future growth, it is important to forecast the effects of such growth on
working capital needs, and building these effects into the cash flows.
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Components of FCFE Change in Working Capital
Changes in net working capital (WC)
Investments in current assets used in
a firms operations are partially
financed by increases in current
liabilities
The end result is an outlay for
working capital equal to the change
in operating net working capital
We may not want to always exclude
cash and marketable securities
because some firm require liquidity
to support operations/growth.
1Referred to as change rather than increase since the change can be both positive and negative.
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Calculating FCFE Levered Firm
FCFE = (EBIT-I)(1 – T) + DA – CAPEX – WC P + NP
Which is the same as:
FCFE = NI + DA CAPEX WC P + NP
(EBIT I)(1 – T): Net income after taxes
NI: Net Income
P: Principal payments on the firms outstanding debt
NP: Net proceeds from the issuance of new debt
When a firm uses debt the two cash flow consequences are net proceeds (inflow) and
cash outlays for principal and interest payments. Since interest expense is tax
deductible, it reduces the taxes the firm has to pay.
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What impact does borrowing have on FCFE?
Borrowing to finance an investment results in financial leverage
This will have some impact on the interest tax shields and reduce the cash flow
available to equity.
Therefore, the risk of uncertain cash flows must be absorbed by the equity
holders.
Because of the higher risk, shareholders require higher rates of return to entice
them to invest in levered projects
In summary, you can continue to borrow (hence increase leverage) which will pump
up your FCFE but at the other end of the ledger your levered beta will increase
thereby generating a higher discount rate.
Dividends and share repurchases are uses of these cash flows so do not affect free
cash flow.
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Calculating FCFF
Combines the cash flow available for distribution to all the firms sources of
capital.
FCFF = EBIT(1-T) + DA WC CAPEX
Where are the tax-savings from interest payments in this cash flow?
This can also be expressed in the following way:
FCFF = NI + DA + Interest(1- Tax Rate) WC CAPEX
Where;
NI = (EBIT-Interest) x (1-Tax Rate) = EBIT(1-Tax Rate) Interest (1-Tax Rate)
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Computing FCFF from the Statement of Cash Flows
Analysts frequently use cash flow from operations, taken from the statement
of cash flows, as a starting point to compute free cash flow because cash
flow from operations (CFO) incorporates adjustments for expenses (such as
depreciation and amortisation) as well as for net investments in working
capital.
Cash flow statements may be useful to the end user because for such items
like interest expense they allow the company to classify it as either an
operating or financing activity.
To estimate FCFF by starting with CFO:
FCFF = CFO + Interest(1-Tax Rate) – CAPEX
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Equity v Firm Valuation
Use Equity Valuation:
a) For firms which have stable leverage, whether high or not, and
b) If equity (stock) is being valued.
:
a) For firms which have leverage which is too high (or too low) and expect to change
leverage over time.
This is because debt payments and issues do not have to be factored in the cash flows and the discount
rate (cost of capital) does not change dramatically over time.
b) For firms where you may have partial information on leverage (e.g. interest
expenses are missing).
c) In all other cases where you are interested in valuing the firm (i.e. value consulting).
The University of Sydney Page 1
FINC6600
Presented by
Craig Mellare
University of Sydney Business School
Topic 6B Terminal Value
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Learning Objectives
What is terminal (continuing) value?
How do we determine the length of the forecast horizon?
What are the different ways of estimating terminal value?
What is a reasonable growth rate?
What are some alternative ways of thinking about the growth rate?
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Closing out a Valuation
A publicly traded firm is assumed to have an indefinite life. The value is therefore equal
to the present value of its future cash flows.
In other words:
Since we cannot estimate cash flows forever, we estimate cash flows for a growth period
and then estimate a terminal value to capture the value at the end of the period.
We are therefore making simplifying assumptions about a firms performance (constant
rate of growth on existing and new capital)
=
= +
=
t
t t
t
(1 r)
CF Value
1
t
t N
t t
t
(1 r)
TV
(1 r)
CF Value
+
+
+ = =
=1
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In other words
To estimate a companys value, we separate a
companys expected cash flow into two periods
and define the companys value as follows:
The second term is the continuing value: the
value of the companys expected cash flow
beyond the explicit forecast period.
Present Value of Cash Flow
during Explicit Forecast Period
Present Value of Cash Flow
after Explicit Forecast Period
Value = +
Explicit Forecast
Period
Continuing
Value
0
2,000
4,000
6,000
8,000
10,000
12,000
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
$ million
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Terminal (continuing) value
We prioritise the terminal value because it represents a sizeable portion of any valuation
analysis.
In the same way that non-current assets (fixed assets) make up a significant proportion of
total assets, so does the terminal value for an intrinsic valuation.
We should be careful, however, not to prioritise the terminal value over the forecast horizon
valuation just because it constitutes a bigger proportion of the valuation. There are at least two
reasons for this:
1) Estimates of continuing value depend on decisions and assumptions made in the earlier
period.
2) A larger continuing value does not mean that more value has been created in this period; Rather it just means that the amount of economic profit generated in the period is higher than in the forecast horizon period.
If our cash inflows in the short-term are offset by investment in fixed assets (cash outflows
in the same period), then our future cash-flows, and hence our continuing value is a function
of the building blocks we put in place during the forecast horizon period.
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How do we estimate Terminal Value?
Terminal Value can be estimated a number of ways. The most common approaches
include:
1. Stable Growth Model
This method requires you to make a judgement about when a firm will grow at a stable
rate for which it will need to sustain.
Gordon Growth Model
2. Multiple Approach
Easiest approach but makes the valuation a relative one.
3. Liquidation Value
Most useful when assets are separable and marketable.
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Gordon Growth Model
The value of continuing cash flows can be determined using the Gordon
Growth model. This looks like:
It factors in the continuing free cash flow of the firm, the associated cost
of capital, and the perpetual growth rate on cash flows.
=
1
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Stable Growth Model
We are we assuming in this model:
A stable rate of growth?
A stable capital structure?
Fixed/Stable taxes?
Does it make sense to assume fixed/stable assumptions regarding
these factors?
What about Cost of equity?
Lever an unlevered beta with the D/E expected for the continuing
period.
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How to get the right terminal value
1. Select a reasonable growth rate
2. Select a reasonable forecast horizon
3. Think about the return on invested capital
4. Be consistent in your model
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Think about the make-up of growth rates
Remember that growth is a function of:
Return on Invested Capital (new + old)
The level of re-investment (versus payout)
In stable growth, you cannot count on efficiency delivering growth and you have to
re-invest to deliver the growth rate that you have forecast.
Therefore, your reinvestment rate in stable growth will be a function of your stable growth
rate and what you believe the firm will earn as a return on capital in perpetuity.
There is some contention about this issue.
Some prominent authors have taken the position that the return on capital cannot exceed
the cost of capital forever.
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Time Are all forecast horizon periods the same?
Reaching a steady state causes all sorts of confusion
Does this mean that a company ceases to earn in excess of the cost of capital or is it
simply confined to new investment.
The explicit forecast period must be long enough for the company to reach a steady state,
defined by the following characteristics:
The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year.
The company earns a constant rate of return on new capital invested.
The company earns a constant return on its base level of invested capital.
In general, an explicit forecast period of 5-10 years is generally recommended perhaps
longer for cyclical companies or those experiencing very rapid growth.
Using a short explicit forecast period, such as five years, typically results in a significant undervaluation of a company or requires
heroic long-term growth assumptions in the continuing value.
We should also remember to undertake a qualitative assessment.
Porters 5 forces, SWOT analysis.
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Gray, Cusatis, Woolridge (GCW, 1999)
Set T = 1 year for boring companies which (1) operate in highly competitive, low
margin industries and (2) have nothing particular going for them.
Set T = 5 years for decent companies with reasonable reputations and propsects.
Set T = 7 years for good companies with good growth potential, brand names,
marketing channels, consumer recognition, or some other recongisable competitive
advantage.
Set T = 10 years for great companies with substantial competitive advantages like
strong marketing power, brand names, or technology.
The University of Sydney Page 13
Looking forward
There is always going to be forecast error (uncertainty) associated with our
estimates.
Certain industries and firms will be more volatile.
How do we handle this volatility from a valuation perspective?
Project/Firm Risk Analysis
Includes sensitivity, scenario, simulation analysis
What do we learn from this type of analysis?
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The End
Next recording I will discuss
relative valuation models for
determining company value
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