DCF with Negative Free Cash Flow
Guys, a quick question. I am doing a DCF for a utility power company and right now it has positive EBITDA but negative FCF due to very high Capex. Obviously I am assuming that it will generate positive FCF in the future( in line with equity research reports I read on the firm). My question is that when calculating EV, do I have to sum all the discounted FCFs( as in the negative ones too?) or just consider the positive cash flow? I would appreciate if someone could explain the logic.
I am assuming we do not have to take the negative FCFs into account bcoz all we are saying is that the firms value is the sum of positive cash flows it generates. Please correct me if I am wrong.
Thanks!
Discounted Cash Flow Model with Negative FCF
If your valuation model has negative cash flow at any point during the projection window, it does need to be included in the sum of the discounted cash flows. Having a few years of negative cash flow will not necessarily result in a negative enterprise value as seen in the image below; if so there is no issue using a DCF to value the business. However, if you are getting a negative share price or enterprise value you should consider using a different valuation method or altering your assumptions if you think that your capex assumptions are too aggressive.
Review of Free Cash Flow
Read more about free cash flow on the WSO finance dictionary.
Read more about the levered vs. unlevered free cash flow on the WSO.
Dividend Discount Model
If your DCF is resulting in a negative share price, you should consider using a different valuation method. The OP should consider using the dividend discount model to value the business. Since regulated utilities often offer a very large dividend this valuation method is appropriate.
You could also consider using the multiples method to value the business.
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All of'em.
You definitely need to take all of the cash flows into account
The whole purpose of calculating a FCF (whether +ve or -ve) is to value them by discounting back to today and arriving at a value of the business.
Hence, if you ignore the -ve FCF you effectively overvalue the business, ignoring the fact that you are paying for cash flows (which you will never get).
If the PV of the total cash flows is ~0 or negative, you may want to question the accuracy of your DCF. Do you want the entire valuation to be derived from the terminal value?
I'm not particularly familiar with utility companies, but I would imagine a P / BV or P / TBV multiple measure would be a more accurate indicator of value. Assuming this is a regulated utility?
use maintenance capex.
Yes it is a regulated company. Right now 65% of my EV is coming from terminal value..rechecking my assumptions..
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