1. The Free Cash Flow to Equity Model
Now we turn to discussing the Free Cash Flow to Equity Model in more detail.
2. What is "Free Cash Flow"?
The first DCF approach you will learn is the Free Cash Flow to Equity or FCFE model. FCFE is cash flow after you have paid off all your suppliers, employees, lenders, and taxes as well as after deducting amounts you need for additional capital investments and working capital. In this course, for simplicity, we will assume new borrowings offset debt repayments. So "Free cash flows" are cash flows you can take away from the firm and give to the shareholders without affecting the operations and growth prospects of the firm.
3. After-Tax Income
The first step in an FCFE calculation is to calculate the after-tax income of the company. We first start with the firm's Revenues or Sales and subtract the Cost of Goods Sold. The difference is called the Gross Profit. We then subtract Operating Expenses from the Gross Profit to arrive at Operating Income. This is sometimes called Earnings Before Interest and Taxes or EBIT. Then, we subtract Interestfrom EBIT to get to Pre-Tax Income. Then, we subtract Taxes from Pre-Tax Income to get to After-Tax Income.
4. Adjustments to Arrive to FCFE
After-Tax Income is calculated using accrual accounting. This means that there are some components of After-Tax Income that are non-cash items. A common non-cash item is Depreciation and Amortization. What is depreciation? When you buy a tangible asset, say, a machine. As the machine gets older, a portion of its value erodes. This erosion in value is what depreciation attempts to capture. Amortization is a similar concept but it applies to intangible assets. Depreciation and amortization reduces taxable income, which is why we need to include it to calculate after-tax income. But, the cash used to acquire the asset that is being depreciated or amortized has already been spent in the past, so we add it back.
Another adjustment is the additional capital investments the firm needs to fund the growth in its projections. If the firm had to buy a new machine next year, for example, we have to spend cash in Year 1 to buy that machine. That would be a drain on our Year 1 cash and should be subtracted to get to our free cash flow.
The last common adjustment is the increase in non-cash working capital. For valuation purposes, working capital is equal to non-cash current assets, like accounts receivable and investory, less noninterest-bearing current liabilities, like accounts payable. Increasing working capital means that you need to invest more cash.
5. Terminal Value
The projections are only for a finite period of time of between 5 to 10 years typically. But firms are assumed to have indefinite lives. So the value of the firm should account for the cash flows the firm receives beyond the 5 or 10-year projection period.
The terminal value is commonly estimated using the Perpetuity with Growth Model. The model takes the FCFE the year after the end of the forecast period and divides it by the difference between the cost of equity and the PGR. This mathematical trick accounts for all cash flows into perpetuity growing at a constant rate.
6. Terminal Value in R
Let's go through an example of coding this in R. Suppose you have the FCFE in the 5th and last year of the forecast period as $100. Also assume that the PGR is 3% and cost of equity is 15%. Then, in R, we need to first grow the Year 5 FCFE by the PGR for one year. Then, divide it by the difference of the cost of equity and Perpetuity Growth Rate to get to $858.
7. Let's practice!
Let's practice!