How do I discount Free Cash Flow to the Firm (FCFF)?

Discounted free cash flow for the firm (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.

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

The short definition of FCFF is the cash flow available to all capital contributors after the firm pays all operating expenses, taxes and other costs of production.

To discount cash flow properly, you first need to be familiar with how to calculate the smaller components of the formula. The most important of these is the weighted average cost of capital (WACC) and the FCFF.

Weighted Average Cost of Capital

Firms rely on the WACC to estimate the weighted cost of all sources of capital. It's a way to allow managers to see how efficiently they finance operations. The formula for WACC can be written as:

 WACC = VE SEDV × CE + VD SEDV × CD × ( 1 CTR ) where: VE = Value of equity SEDV = Sum of equity and debt value CE = Cost of equity VD = Value of debt CD = Cost of debt CTR = Corporate tax rate \begin{aligned} &\text{WACC}=\frac{\text{VE}}{\text{SEDV}}\times\text{CE}+\frac{\text{VD}}{\text{SEDV}}\times\text{CD}\times\left(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×(1CTR)where:VE = Value of equitySEDV = Sum of equity and debt valueCE = Cost of equityVD = Value of debtCD = Cost of debtCTR = Corporate tax rate

Free Cash Flow to the Firm

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

 FCFF = EBITDA × (1  TR) + DA  ×  TR + WC   CE where: EBITDA = Earnings, before interest, taxes, and depreciation TR = Tax rate DA = Depreciation & amortization WC = Changes in working capital CE = Capital Expenditures \begin{aligned} &\text{FCFF = EBITDA}\times\text{(1}-\text{ TR) + DA }\times\text{ 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

Simple Approach to Discounted 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:

 FCFF WACC   Growth Rate \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 includes 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.