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© EduPristine CFA Level – II (2014)© EduPristine – www.edupristine.com

Equity Investment - III

Introduction: Free Cash Flow Valuations

© EduPristine CFA Level – II (2014)


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Cash revenues

Cash revenues

Cash opening

expenses (e.g., tax)

Working capital

investment

Fixed capital

investment

FCFF

© EduPristine CFA Level – II (2014) 3

Interest payments

to bondholders

Net borrowings

from Bondholders

FCFF

FCFE


FCFF

Debt Holders

- Interest * (1-Tax-Rate)


FCFE

+ Net Borrowing

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� Free cash flow (FCF) represents the revenues that a company is able to generate

after subtracting the money required to maintain or expand its asset base.

� Free cash flow is important because it allows a company to pursue opportunities that

enhance shareholder value.

� It can be calculated by taking operating cash flow and subtracting capital expenditures.


It can be calculated by taking operating cash flow and subtracting capital expenditures.

� Negative free cash flow is not bad per se, If free cash flow is negative, it could be a sign

that a company is making large investments.

� If these investments earn a high return, the strategy has the potential to pay off in the

long run.

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Introduction: Free Cash Flow ValuationsFree Cash Flow Valuations-Approaches

Free Cash Flow

FCFF Approach FCFE Approach


FCFF Approach

Used when capital structure

is unstable

Highly levered firm

FCFE Approach

Stable capital structure

Low leverage


� FCFF And FCFE Approaches To Valuations

� FCFF: cash available to shareholders and bondholders after taxes, capital investment and

Working Capital investment.

� FCFE: Cash available to share holders after payment to and from bondholders

( )∑∞

= +=

1 1tt

t

WACC

FCFFValueFirm


FCFE: Cash available to share holders after payment to and from bondholders

� Alternatively

DebtgOutstandinofMVValueFirmValueEquity −=

( )∑∞

= +=

1 1tt

e

t

r

FCFEValueEquity

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Approaches To Calculate Free Cash Flow



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� FCFF AND FCFE: VARIOUS APPROACHES TO CALCUATE

� FCFF

• ={EBIT(1-T)+DEP-FCIinv-WCinv

• ={EBITDA(I-T)+DEP*TAX RATE- FCI inv-WCinv

• =CFO+{Int*(1-Tax rate)- FCI inv


• =CFO+{Int*(1-Tax rate)- FCI inv

• =NI+ Non Cash Charges+Int (I-T)- FCI inv

� FCFE

• =FCFF-Int(1-t)+Net Borrowing

• =CFO- FCI inv+Net Borrowing

• =NI+ Non Cash Charges- FCI inv-WCI inv+Net Borrowing

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� Types Of FCF Models

� Single Stage, Stable growth, GGM model

� Two stage Model

• Fixed growth in stage 1 and 2

• Declining growth in stage 1



� Three stage model

• Fixed growth in all three stages


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� One Stage, Constant Growth

� One stage, constant growth

� FCFE in any period will be equal to FCFE in the preceding period times (1 + g):

• FCFEt = FCFEt–1 * (1 + g).


� The value of equity if FCFE is growing at a constant rate is

� The discount rate is r, the required return on equity.

gWACC

gFCFF

gWACC −

+=

−=

)1(FCFF Value Firm 01

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Income Statement

Net Rev 100

COGS 30

EBITDA 70

Depreciation 10

EBIT 60

Interest 10

= EBITDA*(1-t) + Dep*t – WCInv – FCInv

= 70*(1-30%) + 10*30% – 10 – 30

= 12

= EBIT*(1-t) + Dep -WCInv – FCInv

= 60*(1-30%) + 10 – 10 – 30

= 12

Imp

Calculating FCFF


Interest 10

NI/PAT 35

Cash Flow Statement

WCInv 10

CFO 35

FCInv 30

Tax Rate, t = 30%

= NI + Dep + Int*(1-t) – WCInv – FCInv

= 35+10+10*(1-30%)-10-30

= 12

= CFO + Int*(1-t) – FCInv

= 35 + 10*(1-30%) – 30

= 12

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Approaches To Calculate Free Cash Flow Imp

Income Statement

Net Rev 100

COGS 30

EBITDA 70

Depreciation 10

EBIT 60

Interest 10

= NI + Dep – WCInv – FCInv + Net Borrowing

= 35+10–10–30+15

= 20

= FCFF – Int*(1-t) + Net Borrowing

= 12-10*(1-30%)+15

= 20

Calculating FCFF


Interest 10

NI/PAT 35

Cash Flow Statement

WCInv 10

CFO 35

FCInv 30

Net Borrowing 15

Tax Rate, t = 30%

Target Debt Ratio, DR = 0.5

= NI – (1-DR)*(FCInv - Dep) - (1-DR)* WCInv

= 35-(1-0.5)*(30-10)-(1-0.5)*10

= 20

= CFO – FCInv + Net Borrowing

= 35-30+15

= 20


Sensitivity Analysis

� This analysis is used to understand how sensitive the analyst valuation results are to change

in model inputs like beta, risk free rate etc.

� Any forecasting errors can be detected using sensitivity analysis

� The two major source of errors that could be detected are:-

• Estimating future growth in FCFF and FCFE which in turn depends on sales growth and

profit margin


• The chosen base years for FCFF and FCFE growth forecast

� To perform sensitivity analysis, the analyst provides high and low estimates of various inputs

like growth rate, beta, risk premium etc

� The valuation is done at all the points available.

� If the valuation varies widely for these various range of values it shows it's highly sensitive

to underlying inputs.

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FCFF Forecast And Terminal Value

� Terminal Value = Forecast value at the start of stable growth rate

� FCF forecast is based on operating cash flows

� Non operating assets such as excess cash are valued separately and added to FCFF derived Firm

Value to get Total Firm Value.

� Note: The growth rate of FCFF and the growth rate of FCFE are frequently not equivalent.

� The terminal value can be calculated by multiplying the future earnings into an estimated future

P/E ratio.


P/E ratio.

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Approaches To Calculate Free Cash FlowModels And Discount Rate

How many stages?


single

Firm in mature stage

Has constant growth

multistage

Current high growth will

change to stable


� Ownership Perspective: FCF Or Dividend Discount ?

� FCF models are useful for control perspective, as acquirer

• Who can change dividends

• Control perspective

• Minority shareholder who is a takeover target

� Dividend discount models are useful from minority share holder perspective

• They have no control over dividend policy

� Investors are more likely to pay premium for control perspective and this leads to difference in values of the same firm derived using two models

Imp


the same firm derived using two models

� Recognition Of Value: FCF or Dividend Discount ?

� More often than not Analyst likely to use Cash Flow than Dividend based valuation for recognizing value of firm because:

• Many firms pay no, or low dividends

• Dividends are paid at the discretion of board of directors

• It may not reflect firm's profitability

• If company is being acquired or is a target then free cash flows is more appropriate measure of firm's value

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� FCFE Models Strengths And Limitations

� FCFE Pros

• Practical for various dividends and accounting policies

• Detailed framework provides detailed analysis and insights into the company

• Other measures based on EBIT, EBITDA either double count or ignore cash flows


� FCFE Cons:

• Not able to assess company value if FCFE < 0

• Requires detailed understanding of accounting

• Information not readily available or published

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Approaches To Forecast FCFF And FCFE



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� Two commonly used approaches are

� Historical free cash flow

• Calculate historical values of free cash flow

• Apply growth rate assuming growth rate is constant and will be maintained till infinity

� Components of Free cash flows

• Forecast underlying components of free cash flows

• More realistic and flexible

• This assumes the cash flow is changing at different growth rate in different time horizon


• This assumes the cash flow is changing at different growth rate in different time horizon

• More difficult to compute

• In this method it is common to assume that firm maintains target debt to asset ratio while making new

CapEx and Working Capital investments in future

� DR = target debt/asset ratio

( ) [ ] ( ) )(*1*1 WCInvDRDepCapexDRNIFCFE −−−−−=

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Effects Of Firms Actions On Free Cash flow


Effects Of Firms Actions On Free Cash flow

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Effect Of Various Firm Actions Like Share Repurchase On FCFF And FCFE

� Both FCFF and FCFE are not affected by

• Dividends

• Share Purchase

• Share Issues

� Since both are free cash flows available to investors and shareholders before any financing

decision.


� Minor Effects on FCFE and no effects on FCFF

• Change in Leverage

� Example: Repayment of debt would reduce FCFE in current year but increase projected FCFE

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Proxies For Free Cash flow



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� NI Or EBITDA As Cash Flow For Valuation

� NI is not a good proxy for FCFE

• NI includes non cash charges like depreciation that needs to be added back

• Also investments in CapEx and Working Capital are not included in NI

ngNetBorrowiWCInvFCInvNCCNIFCFE +−−+=


� EBITDA is not a good proxy for FCFF

• It does not reflect tax paid by the firm

• Also investments in CapEx and Working Capital are not included in EBITDA

WCInvFCInvtax*Deptax)(1*EBITDAFCFF −−+−=

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Thank You !

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Equity Investment -III - Amazon Web Servicesdownloads.edupristine.com.s3.amazonaws.com/CFA_II/CFA_Level_II... · Equity Investment -III. Introduction: Free Cash Flow Valuations ©