CFA® Level II · Equities · free lesson

Free Cash Flow Valuation

Free cash flow models value a business on the cash it could distribute, which is why acquirers, private equity firms and equity analysts rely on them when dividends say little about value. This module shows how to choose between free cash flow to the firm and free cash flow to equity, derive both from any set of financial statements, forecast them, and turn them into a value per share with single-stage and multistage models. Level II item sets test these calculations in several linked steps, so the emphasis is on getting every adjustment right.

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What you will learn

1. Contrast FCFF and FCFE valuation, explain the control perspective behind FCFE, and choose the more suitable approach for a given company.

FCFF is cash available to all capital providers; FCFE is cash available to common shareholders after debt flows.
FCFF discounted at WACC gives firm (operating) value; subtract debt and other senior claims and add non-operating assets to reach equity.
FCFE discounted at the required return on equity gives equity value directly.
Free cash flow measures what could be paid out, so FCF models take a control perspective; dividend models suit a minority view.
Prefer FCFF for high or changing leverage and when FCFE is negative; FCFE suits a stable capital structure.

2. Calculate FCFF and FCFE starting from net income, EBIT, EBITDA or cash flow from operations, making the correct adjustments for non-cash items, interest and investment.

FCFF = NI + NCC + Int(1 - t) - FCInv - WCInv; FCFE = FCFF - Int(1 - t) + net borrowing.
Subtract gains and add back losses on asset sales; FCInv is capex minus disposal proceeds.
Working capital investment excludes cash and short-term debt; short-term borrowing belongs in net borrowing.
From EBITDA, add back only the depreciation tax shield (Dep x t), never the full depreciation.
From CFO, add back after-tax interest only if interest paid reduced CFO (always under US GAAP), and add back dividends an IFRS filer deducted in CFO.

3. Forecast FCFF and FCFE, explain how dividends, share repurchases, share issues and changes in leverage affect them, and explain why net income and EBITDA are poor proxies for free cash flow.

Forecast components: sales, then margins, then investment tied to the change in sales.
With a target debt ratio, FCFE = NI - (1 - DR)(FCInv - Dep) - (1 - DR)WCInv.
Dividends, buybacks and share issues do not change FCFF or FCFE; they are uses or sources of equity cash.
New borrowing raises FCFE in that year and lowers it later through interest and repayment; FCFF is unchanged.
Net income and EBITDA ignore required investment (EBITDA also ignores taxes), so they overstate the cash available.

4. Value a firm or its equity with single-stage (constant-growth) FCFF and FCFE models and test the sensitivity of the result to the discount rate and growth assumptions.

Firm value = FCFF1 / (WACC - g); equity value = FCFE1 / (r - g); grow the current cash flow one period first.
WACC uses market-value weights and the after-tax cost of debt.
Equity = firm value - debt - preferred - noncontrolling interests + non-operating assets.
Use only for steady-state companies with g below long-run economic growth and stable leverage.
Run sensitivity analysis on WACC and g; equity value is more sensitive than firm value because debt is fixed.

5. Apply two-stage and three-stage FCFF and FCFE models, estimate the terminal value, and judge whether a share is overvalued, fairly valued or undervalued.

Two-stage: explicit high-growth years, then constant growth; three-stage adds a transition of declining growth.
Gordon terminal value uses the first stable-year cash flow, FCF(n+1), and is discounted back n years.
A multiple-based terminal value should be consistent with stable-growth assumptions; check the multiple the Gordon value implies.
Terminal value often dominates total value, so stress-test the stable growth rate and discount rate.
Judge mispricing by comparing value per share with price, allowing for estimation uncertainty.

Module at a glance

FCFF belongs to all capital providers and is discounted at WACC; FCFE belongs to shareholders and is discounted at the cost of equity.
FCFF = NI + NCC + Int(1 - t) - FCInv - WCInv; FCFE = FCFF - Int(1 - t) + net borrowing.
Leave cash and short-term debt out of working capital; subtract gains and add back losses on asset sales.
Before starting from CFO, check where interest and dividends were classified: add back interest only if it reduced CFO, and dividends if they did.
Dividends, buybacks and share issues leave FCFF and FCFE unchanged; new borrowing raises FCFE in that year.
Single-stage value = next year's cash flow / (discount rate - g); always test sensitivity to the spread.
Multistage terminal value uses the first stable-year cash flow, is discounted back n years, and usually dominates value.

This free module has 5 lessons, 20 practice questions with full explanations.

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