Free Cash Flow as Cash Flow
The value of any asset must equal the present value of its future cash flows, discounted at a rate that reflects its inherent risk. Since neither the future cash flows nor the appropriate discount rate can be known with certainty, valuation is inherently an estimation.
In a discounted free cash flow (DCF) model, investors take the perspective of valuing the firm rather than the stock. The value of the stock can then be determined by dividing firm value by the number of shares. Free cash flow to the firm (FCFE) is simply cash flow from operations less capital expenditures. It is the value of the entire company to all of its investors - bondholders and stockholders alike. To calculate the free cash flow available to equity holders (FCFE), net payments to debtholders (interest plus premium repayment less new borrowing) is subtracted from FCFF.
DCF models are particularly useful when valuing companies that don’t pay dividends, as the cash flow can still be determined even when dividends are not paid. It may be less useful for analyzing growing companies that have significant capital expenditures over the investor’s forecast horizon - in which case FCFF will be lower due to the significant investments in future growth. DCF models are most appropriate when one or more of the following conditions apply:
- The company does not pay a dividend
- The relationship between dividends and cash flow is unclear
- Free cash flow bears an understandable relationship with profitability during the investor’s forecast horizon
- The investor plans to acquire a controlling interest in the company (and can thus influence investments and cash flow).
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
