When I was first introduced to the concept of 'free cash flow' back in my BBA program, I didn't grasp it as clearly as I should or could have. I blame myself for not putting in enough effort to understand the concept back then.
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Now that I have spent a considerable amount of time using ‘free cash flow’ as one of the major valuation methods, I can see how this concept can be learned in an effective way.
In this article, I attempt to explain how businesses generate free cash flow, what it means to investors, and why and how free cash flow is used in company valuation.
The Basic
In a nutshell, free cash flows are the cash flows available for distribution to suppliers of capital.
When we consider free cash flow to the firm (FCFF), it is the cash flow available to both debtholders (those who lend to the company) and stockholders or equity holders (those who buy the stock of the company or have equity ownership of the company).
And when we consider free cash flow to equity (FCFE), it is the cash flow available to stockholders or equity holders.
Compare it to dividends, and you will get a more clear idea.
Dividends are the cash flows actually paid to stockholders, whereas free cash flows are the cash flows available for distribution to shareholders.
How Businesses Generate Free Cash Flow and What it Means to Investors
Now think about a business. What does a typical business do? It manufactures or creates products or services and sells them to its customers. Customers pay for the products or services. The business makes money. In the process of creating the products or services, the business also incurs expenses. The expenses include the costs of manufacturing products or creating services and other expenditures related to operation, which include administrative expenses and marketing expenses. The business makes a profit when the money it earns from selling the products or services is higher than the expenses it incurs. It’s pretty simple, right?
But here, the profit is not the same as the cash it generates from its operation. When it incurs expenses, not all expenses are paid in the current period. When it is making money, which we refer to as revenue in the income statement, not all revenue is earned in cash. The business will get some portion of the cash from selling the revenue in a later period, but it will book the revenue in the current period because it has sold the product. This form of accounting is called accrual-based accounting. So, from the income statement, we don’t get an idea of how much cash the business is generating. We can get it from the cash flow statement, or we can derive it from the income statement by adding back non-cash charges and adjusting for accrual-based transactions.
So, to generate free cash flow, the business first generates cash from its operations — the cash it receives from customers minus the cash it pays to run the operation.
Now, a business also invests. It invests money to increase its capacity or starts a new business segment with the aim of driving growth for the business. When it invests money, we usually call it capital expenditure (capex). A part of the capital expenditure is called maintenance capex, which is needed to maintain the current business capacity, and the other part of the capex can be called growth capex, which increases the capacity of the business to generate more revenue and profit.
But the capex element is not shown in the income statement. It is reflected in the balance sheet and mentioned as an investment cash outflow in the cash flow statement.
So, a business generates free cash flow when it generates a higher amount of cash from its operations than it invests. The positive difference is the cash that is free. If the business has loan or debt, debtholders have a claim on a portion of this cash. And the rest can be distributed to stockholders. The business can either decide to make the distributions or keep the cash for future investments. But it is the cash that is available for distribution to stockholders.
And that’s why a business is often valued on the basis of the cash flow that is available for distribution to stockholders. A higher capacity for generating free cash flow is often rewarded with a higher valuation. So, how can a business generate higher free cash flow?
For this, let’s compare two businesses.
Point 1: Business A and Business B are operating in the same industry and generating the same amount of profit. Business A sells its products to retail clients and gets cash immediately after selling a product. Meanwhile, Business B sells its products to corporate clients, and often the business has to provide credit facilities to the clients to get the large sale order.
Point 2: Business A makes arrangements with its supplier of raw materials for six months of deferred payment, whereas Business B makes advance payments to its suppliers for getting the raw materials.
In both stances mentioned above, Business A is optimizing for the cash conversion cycle, which suggests that it is generating more cash in a shorter period of time compared to Business B. Business A is receiving cash from its clients instantly and deferring its payment to suppliers, which is leaving the business with more cash than its peer, Business B.
Point 3: Business A has a lean manufacturing arrangement where the business imports the parts of its products, assembles them locally, and then sells them. Business B has a full-fledged manufacturing facility where it produces every part of the products and converts them into finished products. So, to run the business or grow the capacity of the business, Business B has to make higher capex compared to Business A, but both businesses have the same profitability margin.
So, considering the points mentioned above, Business A has a higher capacity for generating free cash flow compared to Business B because Business B generates more cash flow from operations and spends less on capex. There are lots of nuances that we are avoiding here to simplify the concept (I will break down those nuances in other articles).
The main point that you should keep in mind is that any business that has a higher capacity to generate cash flow from operations and a lower requirement for capex, both as maintenance capex and growth capex, will have higher free cash flow and should be valued higher compared to its peers.
An investor looks at a business’ free cash flow, or more precisely, sustainable free cash flow, to understand what is available for him each year. A higher free cash flow to equity increases the chance of higher dividends for stockholders.
How to Use Free Cash Flow in Valuing Companies
Once you derive the expected free cash flow, it’s pretty straightforward to value a company. But first, I will share with you the formulas to derive free cash flow.
Straight from the Cash Flow Statement:
Free Cash Flow to Firm = Cash flow from operations - Capital Expenditures
Free Cash Flow to Equity = Cash flow from operations - Capital Expenditures - Payments to (plus receipts from) debtholders.
From Net Income:
Free Cash Flow to Firm = Net Income + Non Cash Charges (Depreciation and amortization is not any form of cash exchange) + Interest Expense * (1-Tax Rate) (Interest expense is payment to debtholders and tax deductible)- Investment in Fixed Capital (Capex) - Investment in Working Capital (to adjust for cash accruals from operations)
Free Cash Flow to Equity = FCFF - Interest Expense * (1-Tax Rate) (to remove the part of cash available for debtholders) + Net borrowing (It increases the cash during the period for stockholders to use)
After you derive free cash flow, you can now use the one-stage discounted cash flow method and capitalization rule to value a company. If you use FCFF, you will be valuing enterprise value, which is the total value of the firm, and to derive equity value, you will have to subtract net debt (debt minus cash) to calculate equity value.
If you use FCFE, you will be directly valuing the equity value of the company.
For FCFF, you should discount the cash flows by weighted average of cost of capital (WACC) where you consider both cost of debt and cost of equity and for FCFE, you should only consider cost of equity.
In another article, I will go into greater detail about the cost of capital and the cost of equity.
You can also use a two-stage discounted cash flow valuation, or you can add more stages if you wish to.
Here, the concept is that a business is valued by its ability to generate free cash flow. So, in free cash flow valuation, we consider the forecasted free cash flow, and to derive the current value, we simply bring those cash flows into present value by discounting them with appropriate rate.
I have embedded two types of free cash flow valuation calculators for you to try. You can take any public company and try to value them with different combination of inputs.
After playing with the calculators, you can also take a short quiz to test your current knowledge of free cash flow.
2-Stage DCF Valuation Calculator (Using Free Cash Flow)
Test your Knowledge
A company has adopted a new strategy to offer credit purchase facilities to its customers with an instalment period of six to twelve months. What is the most likely impact on free cash flow to the firm (FCFF) keeping all other things constant for that year?
A company has decided that the industry it belongs to has entered a mature stage. And from this year on, they will not be investing in additional manufacturing capacity. What is the most likely impact on free cash flow to the firm (FCFF) from this year, keeping all other things constant?
A company’s latest free cash flow to equity (FCFE) is USD 2,500 million. The company’s cost of equity and weighted average cost of capital are estimated to be 10.0% and 8% respectively. Terminal growth is estimated to be 5.0%. What is the company’s equity value?
A company’s latest free cash flow to firm (FCFF) is USD 1,700 million. The company’s cost of equity and weighted average cost of capital are estimated to be 10.0% and 8% respectively. Estimated growth rate for next five years is 8% and thereafter, terminal growth is estimated to be 3.0%. The company has net debt of 3,520 million. What is the company’s equity value?
You are studying two companies in the same industry. Both companies have been posting same profitability margin. In the latest year both have improved their gross profit margin by same magnitude. But Business A has improved their gross profit margin by improving their operational efficiency, whereas Business B has improved their gross profit margin by making advance payments (which is not usual practice in the industry) to its suppliers and getting a discount price on the raw materials. Which business should be fared well when considering the aspect of free cash flow?