DCF with Negative Free Cash FlowSubscribe
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.
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.
Preparing for Investment Banking Interviews?
The WSO investment banking interview course is designed by countless professionals with real world experience, tailored to people aspiring to break into the industry. This guide will help you learn how to answer these questions and many, many more.