Warren Buffet (1992 annual report) said
The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.
Warren Buffet has been focusing on company’s ability to generate Free Cash Flow to Firm. Why does this really matter? This article will focus on understanding what “Free Cash Flows” are in general and why FCFF should be used to measure company’s operating performance. This article is structured as per below –
- What is Free Cash Flows or FCFF
- Layman’s Definition of Free Cash Flow
- FCFF Formulas – Analyst’s formula
- FCFF Example in Excel
- Analysis of Alibaba’s FCFF (positive FCFF and growing firm)
- Analysis of Box FCFF (negative FCFF and growing firm)
- Why does Free Cash Flow to Firm (FCFF) matters
Here we discuss FCFF, however, if you want to know more about FCFE, you can look at Free Cash Flow to Equity.
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#1 – What is Free Cash Flow to Firm or FCFF
In order to gain an intuitive understand of Free Cash Flow to Firm (FCFF), let us assume that there is a guy named Peter who started his business with some initial equity capital (let us assume $500,000) and we also assume that he takes a bank loan of another $500,000 so that his overall finance capital stands at $1000,000 ($1 million).
- The business will begin earning revenues and there would be some associated expenses.
- As for all the businesses, Peter’s business also requires constant maintenance capital expenditure in assets each year.
- Debt Capital Raised in year 0 is $500,000
- Equity Capital raised in year 0 is $500,000
- There is no cash flow from operations and cash flow from investments as the business is yet to start
Scene # 1 – Peter’s Business with not enough earnings
- We assume that the business has just started and generates a modest $50,000 in year 1
- Cash flow from Investments in Assets is higher at $800,000
- Net Cash position at the end of the year is $250,000
- Let us now assume that Peter’s business generated only $100,000 in Year 2
- In addition, in order to maintain and run the business, he needs to regularly invest in assets (maintenance capex) of $600,000
- What do you think will happen in such a situation? Do you think the Cash at the beginning of the year is sufficient?- NO.
- Peter will need to raise another set of capital – this time let us assume he raises another $250,000 from the bank
- Now let us analyze a stressed situation for Peter . Assuming that his business is not doing well as expected and was able to generate only $100,000
- Also, as discussed earlier, maintenance capital expenditure cannot be avoided, Peter must spend another $600,000 to keep the assets running.
- Peter will require another set of external funding to the tune of $500,000 to keep the operations running
- Debt financing of another $250,000 at relatively higher rate and Peter invests another $250,000 as equity capital
- Again in year 4, Peter’s business was able to generate only $100,000 as cash flows from operations
- Maintenance capital expenditure (unavoidable) is at $600,000
- Peter requires another set of funding of $500,000. This time, let us assume that he doesn’t have any amount as equity capital. He again approaches the bank for another $500,000. However, this time the bank agrees to give him loan at a very high rate (given the business is not in good shape and his earnings are uncertain)
- Yet again, Peter was only able to generate $100,000 as cash flows from core operations
- Capital expenditure that is unavoidable still stands at $600,000
- This time the Bank declines to given any further loan!
- Peter is unable to carry forward the business for another year and files for bankruptcy!
- After filing for bankruptcy, Peters business assets are liquidated (sold) at $1,500,000
How much the bank receives?
Bank has given a total loan of $1500,000. Since Bank has the first right to recover their loan amount, the amount received on liquidation will be first used to serve the Bank and Peter will receive the remaining excess amount (if any). In this case, Bank was able to recover their invested amount as the liquidation value of Peter’s Asset is at $1,500,000
How much Peter (shareholder) receives?
Peter has invested his own capital (equity) of $750,000. In this case Peter receives no money as all the liquidated amount goes to the serving of the bank. Please note the the return to the shareholder (Peter) is zero.
Scene # 2 – Peter’s Business Grows and show’s recurring earnings
Let us now take another case study where Peter’s business is not doing bad and is infact growing each year.
- Peter’s business steadily grows from CFO of $50,000 in year 1 to CFO of 1,500,000
- Peter raises only $50,000 in year 2 due to liquidity requirements
- Thereafter he does not need any other set of cash flow from financing to “survive” the future years
- Ending cash for Peter’s Company grows to $1350,000 at the end of year 5
- We see that excess cash is positive (CFO + CFI) from year 3 and is is growing every year.
How much the bank receives?
Bank has given a total loan of $550,000. In this case, Peter’s business is doing well and generating positive cash flows, he is able to payoff the bank loan along with the interest within the mutually agreed time frame.
How much Peter (shareholder) receives?
Peter has invested his own capital (equity) of $500,000. Peter has 100% ownership in the firm and his equity return will now depend on the valuation of this business that generates positive cash flows.
# 2 – Layman’s Definition of Free Cash Flow to Firm (FCFF)
In order to appreciate the layman’s definition of Free Cash Flows or FCFF, we must do a a quick comparison of Case Study 1 and Case Study 2 (discussed above)
|Item||Case Study 1||Case Study 2|
|Revenues||Stagnant, not growing||Growing|
|Cash flow from operations||Stagnant||Increasing|
|Excess Cash (CFO + CFI)||Negative||Positive|
|Trend in Excess Cash||Stagnant||Increasing|
|Requires Equity or Debt to business continuity||yes||No|
|Equity Value / Shareholder’s Value||Zero or very low||More than Zero|
Lessons from the two case studies
- If excess cash (CFO + CFI) is positive and growing, then the company has value
- If Excess Cash (CFO + CFI) is negative for an extended period of time, then the return to the shareholder may be very low or closer to zero
Intuitive Definition of Free Cash Flows – FCFF
Broadly speaking “Excess Cash” is nothing but Free Cash Flow to Firm or FCFF. DCF valuation focuses on the cash flows generated by the Operating Assets of the business and how it maintains those assets (CFI).
FCFF = Cashflows from operations (CFO) + Cashflows from Investments (CFI)
A business generates cash through its daily operations of supplying and selling goods or services. Some of the cash has to go back into the business to renew fixed assets and support working capital. If the business is doing well, it should generate cash over and above these requirements. Any extra cash is free to go to the debt and equity holders. The extra cash is known as Free Cash Flows
#3 – Free Cash Flow – Analyst’s Formula
Free Cash Flow formula can be represented in the following three way –
1) FCFF Formula starting with EBIT
Free Cash Flow to Firm or FCFF = EBIT x (1-tax rate) + Non Cash Charges + Changes in Working capital – Capital Expenditure
|EBIT x (1-tax rate)||Flow to total capital, Removes capitalization effects on earnings|
|Add: Non Cash Charges||Add back all non cash charges like Depreciation, Amortization|
|Add: Changes in working capital||Can be outflow or inflow of cash. Watch for large swings year-to-year in forecasted working capital|
|Less: Capital expenditure||Critical to determine CapEx levels required to support sales and margins in forecast|
2) FCFF formula starting with Net Income
Net Income + Depreciation & amortization + Interest x (1-tax) + changes in Working Capital – Capital Expenditure
3) FCFF Formula starting with EBITDA
EBITDA x (1-tax rate) + (Dep & Amortization) x tax rate + changes in Working Capital – Capital Expenditure
I will leave it to you to reconcile one formula with the other one. Primarily you can use any of the given FCFF formulas. As an Equity analyst, i found it easier to use the formula that started with EBIT.
Additional notes on FCFF Formula Items
- Net income is taken directly from the Income statement.
- It represents the income available to shareholder’s after taxes, depreciation, amortization, interest expenses and the payment to preferred dividends
Non Cash Charges
- Non cash charges are items that affect net income but do not involve the payment of cash. Some of the common non-cash items are listed below
|Non-cash items||Adjustment to Net Income|
|Restructuring charges (expense)||Addition|
|Reversal of restructuring reserve (income)||Subtraction|
|Amortization of bond discount||Addition|
|Amortization of bond premium||Subtraction|
After tax Interest
- Since interest is tax deductible, after-tax interest is added back to the net income
- Interest cost is a cash flow to one of the stakeholder’s of the firm (debt holders) and hence, it forms a part of FCFF
- Investment in fixed assets is the cash outflow required for the company to maintain and grow its operations
- It is possible that a company acquires assets without expending cash by using stock or debt
- Analyst should review the footnotes, as these asset acquisitions may not have used cash and cash equivalents in the past, but may affect the forecast of future FCFF
Change in Working Capital
- The working capital changes that affect FCFF are items such as Inventories, Accounts Receivables and Accounts Payable.
- This definition of working capital excludes cash and cash equivalents and short-term debt (notes payable and the current portion of long term debt payable).
- Do not include non-operating current assets and liabilities, e.g. dividends payable etc
# 4 – FCFF Example in Excel
With the above understanding of the formula, let us now look at the working example of calculating Free Cash Flows. Let us assume that you have been provided the Balance Sheet and Income Statement for a company as provided below. You can download the FCFF Excel Example here
Calculate the FCFF (Free Cash Flow to Firm) for the year of 2008
Let us try to solve this problem using the EBIT approach.
FCFF Formula = EBIT x (1-tax) + Dep & Amort + Changes in Working Capital – Capital Expenditure
EBIT = 285, tax rate is 30%
EBIT x (1-tax) = 285 x (1-0.3) = 199.5
Depreciation = 150
Changes in Working Capital
Capital Expenditure = change in Gross Property Plant and Equipment (Gross PPE) = $1200 – $900 = $300
FCFF = 199.5 + 150 – 75 – 300 = -25.5
Calculating Free Cash Flow to Firm is fairly straightforward. Why don’t you calculate the FCFF using the other two FCFF formulas – 1) Starting with Net Income 2) Starting with EBITDA
#5 – Alibaba FCFF – Positive and Increasing FCFF
On 6th May, 2014, Chinese E-commerce heavyweight Alibaba filed registration document to go to public in the US in what maybe the mother of all Initial Public Offerings in the US history. Alibaba is a fairly unknown entity in the US and other regions, though its massive size is comparable or even bigger than Amazon or eBay. I used Discounted Cash Flow approach for Alibaba’s valuation and found that this amazing company is valued at $191 billion dollars!
Presented below is the Free Cash Flow to Firm of Alibaba. The Free Cash flow are divided into two parts – a) Historical FCFF and b) Forecast FCFF
- Historical FCFF is arrived at from the Income Statement, Balance Sheet and Cash Flows of the company from its Annual Reports
- Forecast FCFF is calculated only after forecasting the Financial Statements (we call this as preparing the Financial Model) Financial Modeling is slightly tricky and I will not discuss the details of Financial Modeling in this article.
- We note that Alibaba’s Free Cash Flow are increasing year after year
- In order to find the valuation of Alibaba, we must find the present value of all the future financial years (till perpetuity – Terminal value)
#6 – Box FCFF – Negative and Growing
On 24th March,2014, Online storage company Box filed for an IPO and unveiled its plans to raise US$250 million. The company is in race to be build the largest cloud storage platform and it competes with the biggies like Google Inc and its rival, Dropbox. In case you want to understand further on how Box is valued, please refer to my article on Box IPO Valuation
Below are the projections of Box FCFF for the next 5 years
- Box is a classic case of high growth cloud company which is surviving due to Cash Flow from Financing (refer Case Study # 1)
- Box is growing at a very fast pace and should be able to generate Free Cash Flows going forward.
- Since Box FCFF is negative for the next 5 years, it may not be wise for us to calculate the value of Box using the Discounted Cash Flow approach. In this case approach using the Relative Valuation is suggested.
- I am rather scared of this IPO and infact wrote an article on Top 10 Scariest Details of Box IPO. Please note that one of the scariest details in Box IPO is company’s Negative Free Cash Flow.
# 7 – Why does Free Cash Flows Matter
- EPS can be tweaked but FCFF can’t – Though EPS is widely used to measure company’s performance, however, EPS can be easily tweaked (due to accounting policies gimmicks) by the management and may not necessary be the best measure for performance. It is best advised to use a measure which is free from accounting gimmicks. Free Cash flow to firm can be one such measure which cannot be manipulated by Accounting Changes.
- Cannot go bust soon if FCFF positive and growing – Companies that produce consistently higher and growing levels of Free Cash Flows are unlikely to go bust any time soon and investors should take this into account while investing in the firm.
- Good indicator for Investors seeking Capital Appreciation – For growth-oriented investors, companies with high Free Cash Flows are likely to invest their free cash for the capital expenditures that are necessary to grow their core business. Growing levels of Free Cash Flows are generally an excellent indicator of future earnings gains.
- Good indicator for Investors seeking Regular dividends – For income investors, Free Cash Flows can be a reliable indicator of a company’s ability to maintain its dividend or even increase its payout.
We note that the excess cash generated by the company (CFO+CFI) can be approximated as Free Cash Flow to the Firm. We also note that EPS may not be the best measure to gauge company’s performance as it is susceptible to accounting gimmicks by the management. A better way to measure company’s performance by Investment banks and investors is to calculate Free Cash Flow to firm (FCFF) as it looks at company’s ability to survive and grow without external sources of funding (equity or debt). Discounting all future Free Cash Flow provided us with the Enterprise Value of the Firm. Additionally, FCFF is widely used not only by the growth investors (looking for capital gain) but also by income investors (looking for regular dividends). Positive and growing FCFF signifies an excellent future earning capabilities, however, negative and stagnant FCFF may be a cause of worry for the business.
If you learned something new or enjoyed the post, please leave a comment below. Let me know what you think. Many thanks and take care.