How Do I Discount Free Cash Flow to the Firm (FCFF)?

To discount cash flow properly, you first need to be familiar with how to calculate the smaller components of the formula—notably, free cash flow to the firm (FCFF). FCFF is simply the cash flow available after the firm pays all operating expenses, taxes, and other costs of production. In this article, we look at why it’s so important and how to calculate it. We also look at another key component of the discount cash flow formula, which is the weighted average cost of capital (WACC).

Key Takeaways

• Free cash flow to the firm is the cash flow that a company has after accounting for expenses and investments.
• FCFF can be used to determine a company’s financial health and well-being.
• Discounted FCFF should be equal to the sum of a company’s cash inflows and outflows
• Although there are different formulas to calculate FCFF, the easiest method starts with EBTIDA.
• The weighted average cost of capital, which is another component of the discounted cash flow formula, estimates the weighted cost of all capital sources.

What Is Free Cash Flow to the Firm (FCFF)?

Free cash flow to the firm is the cash flow from operations that is available to distribute after distribution, expenses, taxes, working capital, and investments are deducted. Put simply, it measures a company’s profitability after accounting for any expenses and reinvestments. Investors and analysts typically use it as a way to determine a company’s financial well-being.

Discounted FCFF should be equal to all of the cash inflows and outflows, adjusted to present value by an appropriate interest rate, that the firm can be expected to bring in during its lifetime. It’s a form of time value analysis – how much an investor would pay today to have the rights to all future cash flow.

Note

Free cash flows aren’t readily available. Financial analysts have to interpret and calculate free cash flows independently. Keep in mind that FCFF is distinct from free cash flow to equity, which does not account for bond creditors and preferred shareholders.

Calculating Free Cash Flow to the Firm (FCFF)

Several competing formulas exist for FCFF. A relatively simple version starts with earnings before interest, taxes, depreciation, and amortization (EBITDA). It can be written as:

$begin{aligned} &text{FCFF = EBITDA}timestext{(1}-text{ TR) + DA }timestext{ TR + WC }-text{ CE}\ &textbf{where:}\ &text{EBITDA = Earnings, before interest, taxes, and depreciation}\ &text{TR = Tax rate}\ &text{DA = Depreciation & amortization}\ &text{WC = Changes in working capital}\ &text{CE = Capital Expenditures}\ end{aligned}$​FCFF = EBITDA×(1− TR) + DA × TR + WC − CEwhere:EBITDA = Earnings, before interest, taxes, and depreciationTR = Tax rateDA = Depreciation & amortizationWC = Changes in working capitalCE = Capital Expenditures​

Weighted Average Cost of Capital (WACC)

As noted above, another key component of discounted cash flow is the weighted average cost of capital. Firms rely on the WACC to estimate the weighted cost of all sources of capital. This includes a company’s stock (common and preferred shares), bonds, and other debt. It’s a way to allow managers to see how efficiently they finance operations.

The formula for WACC can be written as:

$begin{aligned} &text{WACC}=frac{text{VE}}{text{SEDV}}timestext{CE}+frac{text{VD}}{text{SEDV}}timestext{CD}timesleft(1-text{CTR}right)\ &textbf{where:}\ &text{VE = Value of equity}\ &text{SEDV = Sum of equity and debt value}\ &text{CE = Cost of equity}\ &text{VD = Value of debt}\ &text{CD = Cost of debt}\ &text{CTR = Corporate tax rate}\ end{aligned}$​WACC=SEDVVE​×CE+SEDVVD​×CD×(1−CTR)where:VE = Value of equitySEDV = Sum of equity and debt valueCE = Cost of equityVD = Value of debtCD = Cost of debtCTR = Corporate tax rate​

Simple Approach to Discounted Free Cash Flow to the Firm (FCFF)

One simple definition of the value of a firm (and one taught in CFA courses) is equal to the endless stream of free cash flows discounted by WACC. However, much depends on the estimated growth of the firm and whether that growth will be stable.

A single-stage, steady-growth estimation of discounted FCFF can be expressed this way:

$frac{text{FCFF}}{text{WACC }-text{ Growth Rate}}$WACC − Growth RateFCFF​

Multistage models are considerably more complex and best performed by those comfortable with calculus.

Forecasting Future Cash Flows

Predicting future growth and net cash flows is an inexact science at best. There are two common approaches in the financial literature: applying historical cash flow and predicting changes in the underlying components of cash flow.

• It’s easy to use the historical method. If firm fundamentals are solid and not expected to change in the foreseeable future, analysts can apply the historical free cash flow rate.
• The underlying components method isn’t as easy. Revenue growth is matched to the expected returns and costs of future capital expenditures, which include fixed capital replacement and expansion, any depreciation, and changes in working capital.

Do not confuse physical fixed capital, such as machines and factories, with capital financing from debt and equity.

How Do You Read Free Cash Flow to the Firm?

Free cash flow to the firm is the cash flow from a company’s operations that is available for distribution after accounting for depreciation, expenses, taxes, working capital, and investments. It is commonly used to determine the value of a company’s stock.

If a company has a positive FCFF, you may assume that the company has capital available after deducting its expenses. A negative value, on the other hand, means the firm didn’t generate enough money to pay for its costs and investments. As an investor, you’ll want to do more research to understand why there may be a deficit.

What’s the Difference Between Free Cash Flow to the Firm and Cash Flow?

Free cash flow to the firm is the money a company has after accounting for things like expenses, taxes, depreciation, amortization, and investments. Put simply, FCFF is the capital a firm has available after accounting for expenses and capital expenditure. Cash flow, on the other hand, is the amount of money that moves into and out of a company over a certain period. Cash flow is positive when more money moves in, while a negative cash flow is the result of more outflows.

Why Should Investors Care About a Company’s Cash Flow?

Cash flow represents the amount of money that moves in and out of a company within a certain period. It is an indicator of its financial health and well-being.

The Bottom Line

There are many metrics you can use to analyze whether a company is financially viable or is in distress. The free cash flow to the firm indicates what money a company has left over after accounting for its expenses and investments. Keep in mind that it’s always important to use multiple metrics when making your investment decisions. And be sure to compare them to similar companies across the same industry so you make more sound judgments.