How quality companies generate free cash flow?

Cash flow is the lifeblood of any business.

There have been numerous companies that seemed to be very profitable, but were teetering on the edge of bankruptcy because they couldn't turn their profits into cash fast enough.

Profits and cash flow are not the same thing, and it is not sufficient for a company to be profitable to make it a good investment.

After finding out that a company is profitable, is to see how good that company is at turning its profits into cash flow.

A company's future free cash flow is the ultimate determinant of how good an investment the company will be.  Cash flow is the key determinant of its share price and the size of the dividend it will pay out to shareholders - which are the two elements that comprise the total returns from owning a share.

Free cash flow to the firm (FCFF)

Cash flows from operating activities + dividends received from joint ventures - tax paid  = net cash flow from operations

Net cash flow from operations - capex = FCFF

Free cash flow for shareholders (FCF) or Free cash flow for equity (FCFE)

FCFF - net interest (interest received - interest paid) - preference share dividends - dividends to minority shareholders = FCF

How can you use free cash flow numbers to identify good companies to invest in and bad ones to stay away from? 

A company with very little debt and a tiny interest payment, virtually all of the FCFF become FCF or FCFE.  In other words, there is not much difference between FCFF and FCF or FCFE.   This is a positive sign for investors and you should look for this sort of situation in companies you are analysing.

In contrast, a company with lots of borrowings and therefore interest bills to pay, the FCFF and FCF or FCFE will be different.   The interest payment has eaten up a big chunk of the company's FCFF, leaving less FCF or FCFE for shareholders.  In general, it is a good idea to avoid companies with lots of debt.  Too much of their FCFF can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their FCFF to repay debt and lower their future interest bills.  This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Look for a company with vey good long-term track record of producing free cash flow for its shareholders.

Companies that produce lots of free cash flow can make excellent investments.

Free cash flow to equity

From Wikipedia, the free encyclopedia

In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders. The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.

Contents

  [hide] 

• 1Basic formulae
• 2FCFF vs. FCFE
• 3Negative FCFE
• 4Uses
• 5References
• 6External links

Basic formulae[edit]

Assuming there is no preferred stock* outstanding:

${\displaystyle FCFE=FCFF+Net\ Borrowing-Interest*(1-t)}$

where:

• FCFF is the free cash flow to firm;
• Net Borrowing is the difference between debt principals paid and raised;
• Interest*(1–t) is the firm's after-tax interest expense.^[3]

or

${\displaystyle FCFE=NI+D\&A-Capex-\Delta WC+Net\ Borrowing}$

or

${\displaystyle FCFE=NI-[(1-b)(Capex-D\&A)+(1-b)(\Delta WC)]}$

where:

• NI is the firm's net income;
• D&A is the depreciation and amortisation;
• b is the debt ratio;
• Capex is the capital expenditure;
• ΔWC is the change in working capital;
• Net Borrowing is the difference between debt principals paid and raised;
• In this case, it is important not to include interest expense, as this is already figured into net income.

FCFF vs. FCFE[edit]

• Free cash flow to firm (FCFF) is the cash flow available to all the firm's providers of capital once the firm pays all operating expenses (including taxes) and expenditures needed to support the firm's productive capacity. The providers of capital include common stockholders, bondholders, preferred stockholders, and other claimholders.
• Free cash flow to equity (FCFE) is the cash flow available to the firm’s common stockholders only.
• If the firm is all-equity financed, its FCFF is equal to FCFE.

Negative FCFE[edit]

Like FCFF, the free cash flow to equity can be negative. If FCFE is negative, it is a sign that the firm will need to raise or earn new equity, not necessarily immediately. Some examples include:

• Large negative net income may result in the negative FCFE;
• Reinvestment needs, such as large capex, may overwhelm net income, which is often the case for growth companies, especially early in the life cycle.
• Large debt repayments coming due that have to be funded with equity cash flows can cause negative FCFE; highly levered firms that are trying to bring their debt ratios down can go through years of negative FCFE.
• The waves of the reinvestment process, when firms invest large amounts of cash in some years and nothing in others, can cause the FCFE to be negative in the big reinvestment years and positive in others;^[5]
• FCFF is a preferred metric for valuation when FCFE is negative or when the firm's capital structure is unstable.

Uses[edit]

There are two ways to estimate the equity value using free cash flows:

• Discounting free cash flows to firm (FCFF) at the weighted average cost of capital (WACC) yields the enterprise value. The firm’s net debt and the value of other claims are then subtracted from EV to calculate the equity value.
• If only the free cash flows to equity (FCFE) are discounted, then the relevant discount rate should be the required return on equity. This provides a more direct way of estimating equity value.
• In theory, both approaches should yield the same equity value if the inputs are consistent.

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity

*Where there are preferred shares and minority interests, the dividends paid to them must be subtracted from the FCFF to get the FCFE.

How to calculate the Free Cash Flow to Firm and Free Cash Flow to Shareholders

There are two definitions of free cash flow, both of which are useful for investors:

1.  Free cash flow to the firm (FCFF)
2.  Free cash flow for shareholders (FCF).

Free cash flow for shareholders is also referred to as free cash flow for equity.

These can be calculated very easily from a company's cash flow statement.


FCFF

To calculate FCFF, take a company's cash flows from operating activities, add dividends received from joint ventures and subtract tax paid to get the net cash flow from operations.  The subtract capex.

Net cash from operations
less Capital expenditure
add Dividends from joint ventures
= FCFF



FCF

To calculate the FCF, take the FCFF number and subtract net interest (interest received less interest paid), any preference share dividends, and dividends to minority shareholders.


FCFF
less dividends paid to minorities
less interest paid
add interest received
=FCF




When FCFF is not much different from FCF

A company with very little debt and thus, a tiny interest payment, virtually all of the free cash flow produced by the business (FCFF) becomes free cash for the shareholders (FCF).

In such a company, there is not much difference between FCFF and FCF.

This is a positive sign for investors and investors should look for this sort of situation in companies they are analysing.


When FCFF is consistently different from FCF

A company with a lot of borrowings has high interest bills to pay.

In this company, the FCFF and FCF can be consistently different for many years.

This is because the interest payments eat up a big chunk of the company's FCFF, leaving less FCF for shareholders.




Avoid companies with lots of debt

In general, it is a good idea to avoid companies with lots of debt.

• Too much of their free cash flow to the firm can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their free cash flows to repay debt and lower their future interest bills.

• This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Additional notes

Free cash flow to the firm (FCFF)

The amount of cash left over to pay lenders and shareholders.

Operating cash flow less tax and capex.


Free cash flow (FCF)

The amount of cash left over after a company has paid all its non-discretionary costs.

It is the amount of cash that the company is free to pay to shareholders in a year.

Operating cash flow less tax and capex, interest paid and preference dividends.

Calculating Intrinsic Value

Free Cash Flow of Firm

FCFF = CFO - Capex
Enterprise Value = FCFF / WACC
Enterprise Value = Equity Value + Net Debt
Equity Value = Enterprise Value - Net Debt


Free Cash Flow of Equity

FCFE = CFO - Capex + Net Debt
Equity Value = FCFE / Required rate of return on equity


Equity Value = Intrinsic Value


Investors compare this Equity Value to the Market Value in their investing.

Market Value > Equity Value = Overvalued
Market Value = Equity Value = Fair Value
Market Value < Equity Value = Undervalued



Additional Notes:

Assuming there is no preferred stock outstanding:

Interest*(1–t) is the firm's after-tax interest expense

If company has zero debt, its FCFF = FCFE

Using Free Cash Flow to Equity to derive the Equity or Intrinsic Value of a Stock

Free cash flow to equity

From Wikipedia, the free encyclopedia

In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders.^[1][2] The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.

Contents

  [hide] 

• 1Basic formulae
• 2FCFF vs. FCFE
• 3Negative FCFE
• 4Use
• 5References
• 6External links

Basic formulae[edit]

Assuming there is no preferred stock outstanding:

${\displaystyle FCFE=FCFF+Net\ Borrowing-Interest*(1-t)}$

where:

• FCFF is the free cash flow to firm;
• Net Borrowing is the difference between debt principals paid and raised;
• Interest*(1–t) is the firm's after-tax interest expense.^[3]

or

${\displaystyle FCFE=NI+D\&A-Capex-\Delta WC+Net\ Borrowing}$

where:

• NI is the firm's net income;
• D&A is the depreciation and amortisation;
• Capex is the capital expenditure;
• ΔWC is the change in working capital;
• Net Borrowing is the difference between debt principals paid and raised;
• In this case, it is important not to include interest expense, as this is already figured into net income.^[4]

FCFF vs. FCFE[edit]

• Free cash flow to firm (FCFF) is the cash flow available to all the firm’s providers of capital once the firm pays all operating expenses (including taxes) and expenditures needed to support the firm’s productive capacity. The providers of capital include common stockholders, bondholders, preferred stockholders, and other claimholders.
• Free cash flow to equity (FCFE) is the cash flow available to the firm’s common stockholders only.
• If the firm is all-equity financed, its FCFF is equal to FCFE.

Negative FCFE[edit]

Like FCFF, the free cash flow to equity can be negative. If FCFE is negative, it is a sign that the firm will need to raise or earn new equity, not necessarily immediately. Some examples include:

• Large negative net income may result in the negative FCFE;
• Reinvestment needs, such as large capex, may overwhelm net income, which is often the case for growth companies, especially early in the life cycle.
• Large debt repayments coming due that have to be funded with equity cash flows can cause negative FCFE; highly levered firms that are trying to bring their debt ratios down can go through years of negative FCFE.
• The waves of the reinvestment process, when firms invest large amounts of cash in some years and nothing in others, can cause the FCFE to be negative in the big reinvestment years and positive in others;^[5]
• FCFF is a preferred metric for valuation when FCFE is negative or when the firm's capital structure is unstable.

Use[edit]

There are two ways to estimate the equity value using free cash flows:

• Discounting free cash flows to firm (FCFF) at the weighted average cost of capital (WACC) yields the enterprise value. The firm’s net debt and the value of other claims are then subtracted from EV to calculate the equity value.

Enterprise Value EV = FCFF/WACC

Enterprise Value EV = Equity Value + net Debt

Equity Value = Enterprise Value EV - net Debt

• If only the free cash flows to equity (FCFE) are discounted, then the relevant discount rate should be the required return on equity. This provides a more direct way of estimating equity value.

Equity Value = FCFE/required return on equity

• In theory, both approaches should yield the same equity value if the inputs are consistent.

Notes:

Equity Value = Intrinsic Value of the Company

FCFF / WACC = Enterprise Value
Enterprise Value = Equity Value + Net Debts
Equity Value = Intrinsic Value of the stock = Enterprise Value - Net Debts

FCFE = CFO - Capex + Net Debts
Equity Value = Intrinsic Value of the stock = FCFE/required rate of return on equity
Equity Value < Market Value = Overvalued

Equity Value = Market Value = Fair Value
Equity Value > Market Value = Undervalued

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity

The Free-Cash-Flow to-Equity (FCFE) Model

Many analysts assert that a company's dividend-paying capacity should be reflected in its cash flow estimates instead of estimated future dividends.

FCFE is a measure of dividend paying capacity.

It can also be used to value companies that currently do not make any dividend payments.

FCF can be calculated as:

FCFE = CFO - FC Inv + Net borrowing


Analysts may calculate the intrinsic value of the company's stock by discounting their projections of future FCFE at the required rate of return on equity.




Reference:

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity