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=((value of equity)/(sum of equity and debt value))×(cost of equity)+((value of debt)/(sum of equity and debt value))×(cost of debt)×(1 - 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 x (1 - tax rate) + (Depreciation & Amortization) x (tax rate) + (changes in Working Capital) - (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)
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.