Free Cash Flow – the real money

If you plan to use the Discounted Cash Flow method to value a company, understanding free cash flow and being able to calculate it is essential. In this section we will start by understanding what is Free cash flow; later on  we will go into explaining how do we forecast it? What is the Discounted Cash Flow method and how do we use it to value a company? And finally a few tips on the search process involved in purchasing a business.

Free cash flow (FCF) is the money that belongs to the owners of the company (shareholders and loan providers).  It is a very important measure of value as it is the money available to distribute to these owners. Free cash flow can also be viewed as a measure of liquidity.

The reason this section is titled “the real money” is because FCF is the money that the company has at any given point. Sales are not entirely cash, there are account receivables for example; Net income is not cash as it includes many non cash expenses, for example depreciation or provisions.

We will discuss two types of FCF: Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE). As we go through these two terms I hope the meaning and importance of the free cash flow measure becomes more apparent. If things are not clear, or you disagree with anything I say, you really should comment and let me know.

Free Cash Flow to the Firm

The Free Cash Flow to the firm (FCFF) is the cash that is available to be distributed to all sources of capital; that is debt and equity providers. Recall that there are two sources of capital, debt from banks, for example, and equity from shareholders.

FCFF = NI + NCC + Interest (1 – Tax rate) – Change in PP&E – Change in Working Capital

Understanding the definition of FCFF makes it easy to memorize its formula, let us take it step by step:-

1. The Free Cash Flow to the firm (FCFF) is the cash: So it is cash that is available in the company. But this tells me nothing, I mean if I am looking for “cash” there are three typical accounts that people often look at when they thing “cash” : Sales, net income, or cash flow from the cash flow statement.
   • Surely it cannot be sales, because I want free cash flow and sales are not free, they are to be used to cover wages of employees, bills, taxes, and all other expenses.
   • So it must be either net income or cash flow from the cash flow statement, and that is true. There are two ways to calculate the FCFF, one starting from the net income (which we will discuss first) and the other starting from the cash flow from operations.
2. We start with the NI, but NI is sales after expenses have been paid, some of which are non cash expenses. Therefore we need to adjust the NI to get a figure before these non cash distributions have been made:

• FCFF = NI + XXX + XXX – XXX – XXX

• FCFF = NI + NCC+ XXX – XXX – XXX: Adjust for the Non-cash charges (NCC); these are often deducted from sales to get the NI. This money in reality was never paid out and is still in the company and should be given to the owners of the company (lenders and shareholders). An example of a non cash expense is depreciation or amortization.

• FCFF = NI + NCC+ Interest (1 – Tax rate) – XXX – XXX: Adjust for the interest; remember we said that the FCFF is the cash available to all sources of capital, one of which are lenders, who are paid the interest. Since the interest was an expense deducted from the sales when the NI was calculated, it should be added back. The reason we deduct taxes is because in countries where income is taxed, the lenders will be taxed for this money (interest) that they receive.

• FCFF = NI + NCC+ Interest (1 – Tax rate) – Change in PP&E – XXX: Any money that management needs to use in order to buy new property plant and equipment (PP&E) is not available to the owners of the company. For example a company needs new delivery trucks; this is a capital investment that will reduce the cash available to be distributed to the company owners.

• FCFF = NI + NCC+ Interest (1 – Tax rate) – Change in PP&E – Change in Working Capital: Just like the PP&E;  for a company to operate it needs investments in the working capital, which is money needed to undertake its day-to-day operations. Cash to cover for such investments is therefore not available to be distributed, and thus should be reduced from the Net Income.

Let us take very simple business as an example to understand free cash flow:

“The summer season is coming and little Prince wants to open a Lemonade stand to make enough money to buy a Play Station.  Prince was able to convince his mother to lend him AED 200. He uses the money to buy Lemonade, sugar and a wooden stand. As the day progresses this is what happens:

This AED 280 is the Free Cash Flow that Prince has. It is the income he made from his work, he paid the employees (his sister), there is no depreciation, he paid for his fixed assets, and he paid for his working capital (lunch). What remains is money to be given to the owners of the company, Prince and his parents.

From here it becomes easy to understand how to calculate FCFF using the Cash Flow from operations (CFO).

• First remember that the formula for the FCFF starting with the NI is:

FCFF = NI + NCC + Interest (1 – Tax rate) – Change in PP&E – Change in Working Capital

• The Cash Flow from operations from the cash flow statement is actually the NI adjusted for the non cash expenses, and changes in the working capital. So when we use the CFO as the starting point, what remains are the interest, and investments in PP&E:

1. FCFF = NI + NCC + Interest (1 – Tax rate) – Change in PP&E – Change in Working Capital
2. CFO = NI +NCC – Change in working capital
3. FCFF = CFO + Interest (1 – Tax rate) – Change in PP

So you don’t really have to remember two formulas, just know the original FCFF formula (starting with NI), that we explained above, and from that we derive the FCFF using the CFO, simple!

Free Cash Flow to Equity

The Free cash flow to equity (FCFE) is the amount that a company can pay out as dividends; it is not necessarily the amount they chose to pay however! The amount of dividends paid is often a decision made by the firm’s management, they are influenced by factors like historical dividends payments, as most companies would rather not cut on dividends payments due to the adverse effect that could have on the share price. But I think the definition FCFE is the money a firm can pay as dividends, makes it easier to understand, and thus remember that FCFE is the money available to a firm’s equity providers.

The difference between the FCFF and the FCFE is that, as the name suggests, the FCF to the firm is the cash flow available to the entire firm’s owners (debt and equity providers); while the FCF to equity is the cash flow that is available to the equity owners of the company (no debt providers). As such to calculate the FCFE we can also start with the FCFF formula and adjust for the cash linked to the debtors, these are first, interest that the debt providers will receive due to the loans they gave the company (after tax), and second, the net borrowings of the company. Net borrowing is the calculated as the loans received less the loan paid:

• FCFE is the FCFF adjusted for the cash linked to the debt providers:

1. Remove the after tax interest expense: Interest (1 – Tax rate)
2. Add the Net borrowing

• FCFE = FCFF – Interest (1 – Tax rate) + Net Borrowings
• We know that FCFF = NI + NCC + Interest (1 – Tax rate) – Change in PP&E – Change in Working Capital
• FCFE = NI + NCC + Interest (1 – Tax rate) – Change in PP&E – Change in Working Capital – Interest (1 – Tax rate) + Net Borrowings, thus:
• FCFE = NI + NCC – Change in PP&E – Change in Working Capital + Net Borrowings, also:
• FCFE = CFO – Change in PP&E + Net Borrowings. Just start with the FCFF equation using the CFO, then remove the Interest after tax and add net borrowings.

Before we move further, let us go over the ‘net borrowing’ part in more details, to be honest when I first discovered the FCFE formula, I kept asking myself why do we include the net borrowing part. The reason we subtract the Interest (1 – Tax rate) is clear: because we are calculating the free cash flow available to equity providers so no debt, but then what is the deal with the net borrowings?

Obviously, if you are thinking FCFE is money available to equity holders, so no debt money, adding the net borrowing will cause confusion, as it is money that came from a loan and thus from debt providers?!

Ok, but let us think about the problem from a different angle: The company took a loan 10 years ago and is still paying it back [Net Borrowings = Loan receipt – Loan paid], this money paid by the firm to cover the loan is not available to the equity providers and thus has to be subtracted, and if the ‘loan paid’ amount is more than the ‘loan receipt’ amount the Net borrowing will be a negative number. Similarly any extra cash in company available, over and above, the loan payments is money available to the firm’s equity providers. That is why we have to add the Net Borrowings part (I hope this makes it clearer, if not please comment).

I imagine things might have gotten a little confusing, with all the formulas and how they are related to each other. To make it clearer, let us build a summary table of the formulas and try to understand how they are all related to the original FCFF equation:

 If you are curious and would like to know how free cash flow applies to real life situations, there is a nice article written by Mr. William Kingston that discusses FCF for Amazon. It shows an interesting point of view on the subject, and can be found on:

http://seekingalpha.com/article/82311-amazon-is-free-cash-flow-more-important-than-net-income

I hope this helps explaining free cash flow, as it is important in valuing any company and measuring managerial performance.