Free Cash Flows (FCF) are a critical financial metric used in valuation analysis to determine the intrinsic value of a company. FCF represents the cash generated by a company’s operations that is available for distribution to all its stakeholders, including shareholders and debt holders. It is a key indicator of a company’s financial health and ability to generate returns for investors.
Calculation of Free Cash Flows:
There are two commonly used methods to calculate Free Cash Flows:
FCF from Operations (FCFO):
FCFO measures the cash generated by a company’s core operating activities after accounting for capital expenditures required to maintain and grow the business.
FCFO = Operating Cash Flow – Capital Expenditures
- Operating Cash Flow (OCF): It represents the cash generated or used by a company’s core operating activities, excluding financing and investing activities. It is often derived from the company’s Statement of Cash Flows.
- Capital Expenditures (CapEx): CapEx represents the investments made by a company in long-term assets such as property, plant, equipment, and technology. It is crucial for maintaining and expanding the business.
FCF to the Firm (FCFF):
FCFF considers the cash flows available to all providers of capital, including both debt and equity holders. It is calculated by adjusting FCFO for the tax shield on interest expense and adding back any net borrowing.
FCFF = FCFO + (Interest Expense ×(1−TaxRate)) − Net Borrowing
- Interest Expense: The cost of borrowing, representing the interest paid on debt.
- Tax Rate: The applicable corporate tax rate.
- Net Borrowing: The difference between new borrowings and debt repayments.
Importance of Free Cash Flows for Valuation:
FCF is a fundamental metric used in discounted cash flow (DCF) analysis, a widely used method for valuing companies. It helps estimate the present value of all future cash flows generated by the business.
Real Cash Generation:
FCF represents actual cash generated by the company’s operations, providing a more tangible measure of its financial performance than accounting profits.
Debt Servicing Capability:
FCF is crucial for servicing debt obligations, including interest payments and potential principal repayments. It indicates the company’s ability to meet its financial commitments.
Investment and Growth Potential:
Positive FCF allows a company to reinvest in its business, fund growth initiatives, pay dividends, or reduce debt. It reflects the company’s capacity for future expansion.
FCF analysis provides insights into a company’s ability to withstand economic downturns or financial challenges. Companies with consistent positive FCF are generally considered financially stable.
FCF allows for the comparison of companies across different industries and sizes. It provides a standardized metric to assess their financial performance and value.
Investors use FCF metrics to make informed decisions about buying, holding, or selling a company’s stock. It helps determine whether a stock is undervalued or overvalued.