Free Cash Flow & Enterprise Value question.

JoeySalads's picture
Rank: Monkey | banana points 59

Hey all,

I am writing today seeking help to clear some confusion I have about valuation. It appears that I know the formulas, but I am interpreting the numbers incorrectly, or in fact I cannot explain what is going on or why things are as they are. I would like to start by telling you how I find FCFF and then I want to tell you how I interpret it, how the dictionary interprets it, and why I don't seem to find commonality between the definitions. Alright here I go:

FCF => Profit after tax + Depreciation - Increase in current assets + Increase in current liabilities - Increase in fixed assets at cost + After tax interest on debt - After tax interest on cash and marketable securities

So I do this for a projected 5-10 years, discount them at WACC, and come to find the enterprise value. Now what I was taught at university was that FCF is not profit, this is just the cash available at the end of the projected year for which debt holders or equity holders can put their hand on; ("this is not profit" because there may be accounts receivable which inflated net income but we subtracted any increase in current assets). What I learned in University is that the Enterprise value is basically the PV of all the FCF's. Now let me introduce my confusion:

1) If Enterprise value is the value of the total assets in year 0, and we know FCF does not necessarily represent true profit, why do we construct a valuation model based on cash available at the end of the year which does not embed profit as the final judgement?

2) On most websites, Enterprise value would be defined as (Share price x Outstanding shares) + Net Debt, is this embedding the idea that enterprise value is the present value of total assets in year 0, and total assets are coming from either equity or debt? If so, where did my model take into account discounting my PPE in the future? Yes the formula says "Subtract Increase in fixed assets at cost", but again this seems to be on a cash basis and so the enterprise value does not seem to appear as a valuation figure which takes into account physical assets or non tangible assets, if I were to acquire a firm I would be buying it with its physical assets as well!

3) Since we are discounting CASH figures to get an enterprise value, would it be logical to say enterprise value is the present value of debt and equity of the firm? That link between cash and (debt + equity) is confusing whereas the link between assets and (debt + equity) is easier to understand. It's just that I hear that (debt + equity in DCF = value of operating assets), and then apparently operating assets is proxied by FCF whereas cash is a non operating asset.

4) What's the difference between finding the enterprise value by discounting future FCF's, or doing it as (Market cap + Debt)? I heard it was something like market value vs intrinsic value, but yet still don't understand.

5) Yes I understand the idea that FCF would be the amount left to pay debt holders and equity holders after the year is over, but would discounting those numbers to the present give me a true value of the firm today with all its physical and non tangible assets?

Thanks for making it this far! I know I am in lots of confusion, but I am determined to get a keen understanding of all of this and I thank you all!

Comments (25)

May 25, 2017

What may help is to think of it like this:

Valuation is putting a PV on future cash flows that are generated by the firm. Price paid throws in goodwill, along with other synergies and strategic motives.

Since the FCF is the "cash generated", you have to think about what in the business created that cash in the first place - the balance sheet. Assets and Liabilities funded the business and generated the operations that the firm produces to create that future stream of cash flows. So the intangible and tangible assets are baked into the performance of the firm.

If you're valuing assets by themselves you lose out on everything else that is creating value and you'd probably find yourself underbidding for the firm (unless it's distressed and liquidation value is higher). The efficiency of a single asset to the firm is very difficult to measure, so it doesn't make sense to value a firm based on intangible and tangible assets. Intangible assets are even more difficult to estimate, so you take the final performance of the firm (FCF) as the valuation of the "performance of the assets", per say.

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May 25, 2017

Very interesting way to understand it! Thank you!

May 26, 2017
May 27, 2017
May 27, 2017

@SS1212, enterprise value represents both debt and equity holders, so you want to use the FCF that is available to both debt and equity holders. This is unlevered FCF. The reason that unlevered FCF excludes interest expense is because interest expense is only available to debt holders.

May 27, 2017

Perfect, thank you very much !

May 27, 2017

in my opinion, since you have mentioned unlevered FCF are before Interest Expense (Debt) and Interest Income (Cash), that means this cash flow include the effect of interest, which means include the return to investors.
So it come to enterprise value.

If we want to find out equity value, we will subtract the influence of interest. Then use: discount rate = cost of equity....balabalabala

don't know whether I explain right or not....

May 27, 2017

Yes perfect I understand now, thank you very much !

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Best Response
May 27, 2017

You have got it wrong, the way you explain it doesn't make any sense.

You price the company at a certain IRR given you expect it to be worth 50% more in 4 years, by your example. If exactly that happens, then you realize the IRR you priced it at.

You can condense valuation into the following formula: Value = FCF+1 / (WACC-growth), this is discounted. If FCF+1 is 100, WACC is 12% and growth is 2%, then the value should be 1,000 and you pay 10x FCF for that. If your thesis is that in 5 years, the company can actually double FCF( but needs to reinvest all FCF to do so) i.e it is FCF is 200, the company is twice as big and at the same multiple it is worth twice as much at 2,000. You can either choose to discount this at 12% WACC and decide that the company is actually worth more than the 1,000, or you can take a typical PE approve and see that IRR is ~15% for this company.

May 27, 2017

Understand your IRR example, but still does not make sense to me why the EV should move even if you condense the value into a gordon growth formula. I simply don't understand why EV moves when you exactly meet the expected FCF that you've forecasted. A public companies MCap for example also does not move if it exactly meets the market expectations, so why should the EV move if you exactly meet what you expect. And you don't even have to assume reinvestment, let's say the cash flows generated will be taken out of the company and your FCF continues to increase year by year as you can fund the capex from with your operating cash flow. The EV would in this scenario still increase year by year by 3% if your FCF increases by 3%. What I don't get is why the EV is moving although you already expect FCF to be 3% higher each year.... I know there must be some logical mistake in my thinking, but I don't understand where it lies....

May 27, 2017

The "logical mistake in your thinking" that you refer to is that don't understand discount rates (what it actually is) and expectations. Of course the EV should move when you exactly meet the expected FCF you have forecasted.

When doing a DCF you are implicitly assuming that the enterprise value will change over time e.g., the terminal value is what the EV will be at the end of your forecasting period. The DCF is merely the value today (with certain expectations), but those expectations can reflect an expected increase in the EV.

A simple example, your cost of capital for company is 10% and you buy that for 100 with a holding period of one year. Implicitly you are expecting that that you will be able to sell it for 110 in a years time. You have discounted the EV in a years time to today at your cost of capital.

Now that 10% appreciation clearly has to come from somewhere? There are primarily three sources of value creation (i) yield, (ii) growth and (iii) multiple expansion. Say that this company had 5m of FCF and you assumed same multiple at exit as entry. Then your FCF yield at setup is 5% and your "implicit" growth expectations in order to get to the 10% return is 5%.

Your expectation is that the EV appreciates by 10% (your cost of capital/expected return). If it instead turns out to grow by 10% (and no multiple expansion), then your EV has increased by 15% and your return will have also been 15% vs. your cost of capital at 10%.

May 27, 2017

You are way over complicating this. Multiple of earnings takes into account growth estimates, but obviously you still reap benefits of expanding business unless multiple compression offsets (e.g. people think you used to grow at 10% and now it will be flat...)

You buy a business with $10M EBITDA for 10x = $100M EV

You exit in 5 years at $15M EBITDA for 10x = $150M EV.

Constant multiple means you increased EBITDA by 50%, which translates directly to EV increasing 50%,

May 27, 2017

SOAB, bummer your thread hasn't had a response yet. Sometimes bots are smarter than humans anyways:

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  • Free Cash Flow & Enterprise Value question. FCF's. Now let me introduce my confusion: 1) If Enterprise value is the value of the total assets in year ... again this seems to be on a cash basis and so the enterprise value does not seem to appear as ... = value of operating assets), and then apparently operating assets is proxied by FCF whereas cash is a non ...
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  • Levered vs. Unlevered Free Cash Flow Difference a discounted cash flow with unlevered free cash flow- you will calculate the enterprise value. Free cash flow ... levered free cash flow- you will calculate the equity value. Levered free cash flow
  • DCF with Negative Free Cash Flow and many, many more. Investment Banking Interview Course Here dcf free cash flow ... Negative FCF If your valuation model has negative cash flow at any point during the projection window, it ... flow will not necessarily result in a negative enterprise value; if so there is no issue using a
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  • DCF- Free Cash Flow to Firm/Equity HELP called Unlevered FCF, FCFE(free cash flow to Equity) also called Levered FCF? 2, FCFF discounted by WACC ... Hi guys, just want to make sure a few facts straight here, 1, FCFF(Free Cash Flow to Firm) also ... (cost of equity is calculated using unlevered Beta)=Enterprise Value FCFE discounted
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Fingers crossed that one of those helps you.

May 27, 2017

Simple answer:

Cash is almost always paid out upon closing to existing shareholders. Shareholders get the purchase price + cash on the books less debt obligations.

Acquisitions are almost always made cash free, debt free. There are SOME exceptions, but for conceptual purposes, you want to assume that existing debt goes away and cash goes away when looking at the balance sheet.

Don't confuse existing cash with cash flows.

May 27, 2017

Thanks for the reply. Are you saying that upon an acquisition of a company, the company being acquired tries to pay down all of its current debt with all of its existing cash levels? So the method of getting to EV from my aforementioned methods are conceptually sound?

Another question about acquisitions while on that topic, I know that if you are trying to acquire a public company, you can't just take like 51% (or however much you're going to buy of that company for controlling stake) of the market capitalization as your cost. There's control premiums, but I figure that the price of a stock goes up as you purchase up more shares because of putting on buying pressure. Is there a way to account for this or some sort of process to account for the share price increasing?

May 27, 2017
LiquidMarket:

Thanks for the reply. Are you saying that upon an acquisition of a company, the company being acquired tries to pay down all of its current debt with all of its existing cash levels? So the method of getting to EV from my aforementioned methods are conceptually sound?

Another question about acquisitions while on that topic, I know that if you are trying to acquire a public company, you can't just take like 51% (or however much you're going to buy of that company for controlling stake) of the market capitalization as your cost. There's control premiums, but I figure that the price of a stock goes up as you purchase up more shares because of putting on buying pressure. Is there a way to account for this or some sort of process to account for the share price increasing?

Upon an acquisition the target's cash (under an asset sale) can either be kept by the sell it self, or is used to finance the deal or anything in that nature. seller's existing debt is usually paid off by the buyer not the seller. (debt,cash-free balance sheet. at least for most MM deals)

May 27, 2017

Hmm, still not 100% understanding this unfortunately.

Let's do a scenario. If a company has something like $10 B of cash on the books without any debt, how can simply forecasting FCF and discounting it back account for all of that cash? You'd arrive to an EV using the FCFs but does that not neglect the value on the balance sheet? It seems to me like that EV does not include the $10B of cash. If it gets paid out to shareholders, does that not still provide value above and beyond the model?

Would this mean the book value > market value?

May 27, 2017

Correct, the FCF model does not account for the cash (more specifically the excess cash and other short-term investments) on the balance sheet. The FCF model values the underlying cash-generating assets and produces the takeover cost, or EV, of a company.Cash is not included because it is assumed to be instantaneously absorbed by the acquirer.

To be more illustrative, an easy question to ask yourself is - how much would it cost for you to buy a 30$ wallet with a 20$ bill inside? Is the answer really $50? No, the net cost would be 30$ irrespective of how much cash I put in the wallet. In other words, the acquirer is entirely indifferent to the amount of cash that a company has. The acquirer does not care if company pays a dividend or even if the company dump its money in trash can and lit it on fire, so long as the cash generating assets remain intact.

tl;dr Buying cash with cash creates a moot point. Let me know if that makes sense.

May 27, 2017

Except the answer actually is $50. A $30 wallet with $20 inside should cost $50.

May 27, 2017

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