12.1 Free Cash Flow Estimation

Free Cash Flow (FCF) is a crucial metric in corporate valuation, showing the cash a company generates after expenses and investments. This section breaks down FCF's components, including net income adjustments, operating cash flow, and capital expenditures.

Understanding FCF is essential for assessing a company's financial health and ability to fund growth, pay dividends, or reduce debt. This topic explores different types of FCF, including unlevered and levered, which are used in various valuation models.

Cash Flow Components

Calculating Free Cash Flow

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• Free Cash Flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain capital assets
• FCF is calculated by adjusting net income for non-cash expenses, changes in working capital, and capital expenditures
• Net Income is the starting point for calculating FCF and is found on the company's income statement
• Depreciation and Amortization are added back to net income as they are non-cash expenses that reduce net income but do not affect cash flow
• Changes in Working Capital, such as increases in accounts receivable or inventory, are subtracted from net income as they represent a use of cash

Operating Cash Flow

• Cash Flow from Operations represents the cash generated by a company's normal business operations
• It excludes cash flows from investing and financing activities
• Cash Flow from Operations is calculated by adjusting net income for non-cash items and changes in working capital
• Non-cash items added back to net income include depreciation, amortization, and stock-based compensation
• Changes in working capital, such as increases in accounts payable or decreases in accounts receivable, are added to net income as they represent a source of cash

Capital Investments

Capital Expenditures

• Capital Expenditures (CapEx) are funds used by a company to acquire, upgrade, or maintain long-term assets such as property, plant, or equipment
• CapEx is subtracted from Cash Flow from Operations when calculating FCF as it represents a cash outflow
• Examples of CapEx include purchasing new machinery, constructing a new factory, or investing in research and development
• CapEx is found on the company's cash flow statement under the investing activities section

EBITDA and Capital Investments

• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a measure of a company's operating performance
• EBITDA is calculated by adding depreciation and amortization expenses back to operating income
• EBITDA is often used as a proxy for cash flow from operations, but it does not account for changes in working capital or capital expenditures
• When evaluating a company's ability to generate cash flow, it is important to consider both EBITDA and capital investments
• A company with high EBITDA but also high capital expenditures may have lower FCF compared to a company with lower EBITDA but also lower capital expenditures

Types of Free Cash Flow

Unlevered Free Cash Flow

• Unlevered Free Cash Flow (UFCF) represents the cash flow available to all investors, including both debt and equity holders
• UFCF is calculated by adding after-tax interest expense back to FCF
• After-tax interest expense is added back because it represents a cash outflow to debt holders, but not to the company as a whole
• UFCF assumes that the company is financed entirely with equity and does not have any debt
• UFCF is often used in valuation models to determine the enterprise value of a company

Levered Free Cash Flow

• Levered Free Cash Flow (LFCF) represents the cash flow available to equity holders after accounting for debt payments
• LFCF is calculated by subtracting after-tax interest expense and principal repayments from FCF
• After-tax interest expense and principal repayments are subtracted because they represent cash outflows to debt holders
• LFCF assumes that the company is financed with a mix of debt and equity
• LFCF is often used in valuation models to determine the equity value of a company
• The difference between UFCF and LFCF is the cash flow that goes to debt holders in the form of interest and principal payments