Definition: Cash flow available after all obligations and capital expenditure.
Focus: Cash flows, not profits.
Adjustments Required:
Start with Profit After Tax (PAT).
Adjust for depreciation.
Consider capital expenditure (CapEx).
Adjust for changes in working capital.
Objective: To determine cash flow available to the entity (not restricted by dividend payments).
Types of Free Cash Flow:
FCFF (Free Cash Flow to Firm):
From the business perspective.
Calculated without considering debt.
Formula: FCFF = NOPAT (Net Operating Profit After Tax) + Depreciation - CapEx - Increase in Working Capital
FCFE (Free Cash Flow to Equity):
From the owner's perspective.
Considers debt obligations.
Formula: FCFE = PAT + Depreciation - CapEx - Increase in Working Capital + Net Borrowing (i.e., Loans taken minus repayments)
Valuation Methodologies
Perpetual Growth Model:
FCFF/FCFE is divided by (WACC - Growth rate) for firm or equity valuation.
Enterprise Value (EV):
Calculated as FCFF divided by WACC minus growth rate.
Practical Application
Example Scenario: House Property Valuation
Considered property value, debt, and equity.
Calculated FCF based on realistic financial activities related to property maintenance and improvements.
Key Takeaways:
FCF provides an intrinsic measure of the cash flow available to a firm or its equity holders.
Adjustments for depreciation and capital expenditures are crucial to align the theoretical assumptions of firm valuation with practical realities.
Valuation models rely heavily on accurate financial predictions and require a thorough understanding of the firm’s capital structure and financial obligations.