Introductory Corporate Finance: Valuation - Free Cash, Flow Valuation FCFF and FCFE Models Enterprise Value

What This Is

Free Cash Flow Valuation (FCFV) is a method used to estimate a company's intrinsic value by calculating its free cash flows. This approach is essential in corporate finance as it helps investors and analysts determine a company's true worth, beyond its market capitalization. For instance, let's consider Tesla, Inc. (TSLA). In 2022, Tesla generated $12.6 billion in free cash flow, which is a significant indicator of its financial health. By using the free cash flow valuation model, we can estimate Tesla's enterprise value and determine its intrinsic value.

Key Formulas & Models

• FCFF = EBIT(1-T) + Depreciation - Capital Expenditures - ?Working Capital – free cash flow to the firm; measures cash available to all stakeholders.
  • EBIT: earnings before interest and taxes
  • T: tax rate
  • Depreciation: non-cash expense
  • Capital Expenditures: investments in property, plant, and equipment
  • ?Working Capital: change in working capital
• FCFE = FCFF + Interest - Preferred Dividends – free cash flow to equity; measures cash available to shareholders.
  • Interest: interest expense
  • Preferred Dividends: dividends paid to preferred shareholders
• Enterprise Value = Market Capitalization + Debt - Cash and Equivalents – enterprise value; measures a company's total value, including debt and cash.
  • Market Capitalization: market value of outstanding shares
  • Debt: total debt outstanding
  • Cash and Equivalents: cash and cash equivalents on hand
• WACC = wd × rd(1-T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: weight of debt
  • rd: cost of debt
  • T: tax rate
  • wps: weight of preferred stock
  • rps: cost of preferred stock
  • we: weight of equity
  • re: cost of equity
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – sustainable growth rate; measures a company's long-term growth potential.
  • ROE: return on equity
  • Retention Ratio: percentage of earnings retained in the business

Step-by-Step Calculation

1. Calculate EBIT: Tesla's EBIT in 2022 was $6.5 billion.
2. Calculate Depreciation: Tesla's depreciation in 2022 was $1.2 billion.
3. Calculate Capital Expenditures: Tesla's capital expenditures in 2022 were $3.5 billion.
4. Calculate ?Working Capital: Tesla's change in working capital in 2022 was -$1.1 billion.
5. Calculate FCFF: FCFF = $6.5B + $1.2B - $3.5B - (-$1.1B) = $5.3B
6. Calculate FCFE: FCFE = FCFF + Interest - Preferred Dividends = $5.3B + $0.2B - $0.1B = $5.4B

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value for WACC to reflect the current market conditions.
  • Counterexample: If a company has a high market value and a low book value, using book value would result in an incorrect WACC.
• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs in the calculation of WACC to reflect the true cost of capital.
  • Counterexample: If a company has a high flotation cost, ignoring it would result in an incorrect WACC.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Use opportunity cost instead of sunk cost to reflect the true cost of a decision.
  • Counterexample: If a company has a sunk cost of $1 million, using it as an opportunity cost would result in an incorrect decision.

Exam / CFA Tips

• Tip: Be careful when using the FCFF and FCFE models, as they have different assumptions and requirements.
• Tip: Make sure to calculate WACC correctly, as it is a critical component of the free cash flow valuation model.
• Tip: Be aware of the differences between sustainable growth rate and actual growth rate.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25% – compute DFL.

Answer: DFL = $10M + $2M = $12M

Explanation: DFL (debt-free leverage) is calculated by adding EBIT and interest expense.

Last-Minute Cram Sheet

• FCFF: free cash flow to the firm
• FCFE: free cash flow to equity
• Enterprise Value: a company's total value, including debt and cash
• WACC: weighted average cost of capital
• Sustainable Growth Rate: a company's long-term growth potential
• ROE: return on equity
• Retention Ratio: percentage of earnings retained in the business
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield
• WACC is a weighted average of the costs of debt, preferred stock, and equity
• Sustainable growth rate is a long-term growth rate, not an actual growth rate