free cash flows v2

Free cash flows
• In discounted cash flow (DCF) valuation, we value an asset by
discounting the future cash flows we expect to receive from
that asset.
• Three common valuation techniques for valuing equity are:
Dividend discount model (DDM)
– When we buy stock, we typically expect to get two types of cash flows –
dividends during the period the stock is held and an expected price at the end
of the holding period. Since this expected price also depends on future
dividends, the value of a stock is the present value of dividends through
infinity. In the strictest sense, the only cash flow you receive from a firm when
you buy its stock is a dividend. Thus, the simplest model for valuing equity is
the dividend discount model (DDM).
Discounting dividends is usually the most conservative estimate of value for
the equity in any firm, since most firms pay out less in dividends than they can
afford to.
The dividend cash flows are calculated as
D = Net income*(1-Retention ratio) = Net income * Payout ratio
Retention Ratio = (NI – Dividends)/NI
Payout Ratio = Dividends/NI
Free cash flows to equity (FCFE)
One problem that arises from using the DDM is that we may misvalue
firms that consistently fail to return what they can afford to shareholders
(i.e., if firms do not pay dividends even when they have no positive NPV
projects to invest in).
The FCFE is the cash flow that is left over after meeting all reinvestment
needs and making debt payments. So, this cash flow could be paid out as
dividends, and therefore will yield a more realistic value of the firm.
The FCFE are calculated as
FCFE  NI  ( CapEx  Depreciati on )   noncashWC
 ( NewDebtIss ued  DebtRepaym
ents )
The equity reinvestment rate, i.e., the rate at which the company is
reinvesting in the firm, net of borrowings) determines the future growth
in FCFE. It is measured as
( CapEx  Depreciati on )   noncashWC
 ( NewDebtIss ued  DebtRepaym
ents )
Free cash flows to the firm(FCFF)
The FCFF is the cash flow to all holders of capital in the firm, i.e., the
equity holders and the bond holders. Free cash flows are essentially
money that the firm can pay out to investors after reinvestment needs
have been met.
Done consistently, the FCFE and the FCFF should give the same value for
equity. However, the FCFE are after net debt issues or payments and
become more difficult to estimate when leverage is changing over time.
FCFF does not have this problem since these are predebt cash flows.
The FCFF are calculated as
FCFF  EBIT 1  t   ( CapEx  Depreciati on )   noncashWC
 EBIT 1  t   Depreciati on  FixedCapit alInvestme nts  WorkingCap italInvest ments
The reinvestment rate, (i.e., the rate at which the company is reinvesting
in the firm), determines the future growth in FCFF. It is measured as
( CapEx  Depreciati on )   noncashWC
EBIT 1  t 
• Sources:
Damodaran, Investment Valuation, 2nd ed.
Damodaran, Applied Corporate Finance, 3rd ed.
Pinto, Henry, Robinson, Stowe, Equity Asset Valuation, 2nd ed.
McKinsey & Company, Koller, Goedhardt, and Wessels, Valuation:
Measuring and managing the value of companies, 5th ed.

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