Free Cash Flow Models
The dividend discount model is based upon the premise that the only cashflows received by stockholders is dividends. Even if we use the modified version of the model and treat stock buybacks as dividends, we may misvalue firms that consistently return less or more than they can afford to their stockholders.This chapter uses a more expansive definition of cashflows to equity as the cashflows left over after meeting all financial obligations, including debt payments, and after covering capital expenditure and working capital needs. It discusses the reasons for differences between dividends and free cash flows to equity, and presents the discounted free cashflow to equity model for valuation.
The Concept of Free Cashflow Free cashflow is at the core of modern valuation techniques. One of the most common and respected standards of valuation of any corporation is to estimate the present discounted value of free cashflow (discussed more below). Techniques used to do this are complicated but the
concept of free cashflow is consistently found at the core of such estimations. Free cashflow is a company’s operating cashflow after investment in new capital but before considering new debt. Copeland, Koller, and Murrin define free cashflow in the following way: “Free cash flow (FCF) is a company’s true operating cash flow. It is the after-tax cash flow generated by the company and available to all providers of the company’s capital, both creditors and shareholders. It can be thought of as the after-tax cash flows that would be available to the company’s shareholders if the company had no debt.”1 The concept of free cashflow works on a related premise that the ultimate origin of long-term corporate growth is invested capital. Generally, productive fixed assets are expected to be at the core of a company’s productive ability, which in turn is essential for the production of commodities sold by the company, which in turn is essential for sales revenues and their growth. Therefore, cash placed into invested capital (increasing net fixed assets) is a primary value driver for long-term sales growth (but not necessarily margins or other measures of profitability).
This concept shows a clear bias towards manufacturing firms. Clearly the growth of productive assets, and in particular net fixed assets, is far less important in service firms, such as large law firms or large consulting firms, or merchandising firms, like sports apparel merchandisers. This isrecently recognized by analysts. For example, Weston, Chung, and Siu have this to say about capital budgeting (for what has traditionally been defined as invested capital): “Capital budgeting represents the process of planning expenditures whose returns extend over a period of time. Examples of capital outlays for tangible or physical items are expenditures for land, building, and equipment. Outlays for research and development, advertising, or promotion efforts may also be regarded as investment outlays when their benefits extend over a period of years.”23 The first group listed in this quotation, all fixed assets, have always been regarded as invested capital. Research and development, however, is of critical importance in such industries as pharmaceuticals and chip design, whereas advertising and marketing outlays are the critical value drivers in many consumer industries such as clothing apparel.
If this premise about the importance of invested capital can be accepted as valid, then an immediate question arises: how is the expansion of productive fixed assets to be financed?
Generally, there are two candidates; (1) internal cashflow and (2) debt. Free cashflow is a measure of cash remaining assuming that new investment capital is financed via internal cashflow (rather than new debt). How does free cashflow differ from other measures of cashflow? Free cashflow equals ordinary operating cashflow after all adjustments, including all categories of depreciation, amortization, and tax payments, minus new investment, but excluding any debt payments and prior to any cash received from new loans.
In notation form
Free Cashflow = Net Operating Cashflow – New Invested Capital (Investment)3
It should be remembered that Net Operating Cashflow does not include interest payments on debt
nor principle reductions of long-term debt, but does include adjustments for accruals,
depreciation, amortization and taxes.