9-801-126 REV: JULY 9, 2002
CARLISS Y. BALDWIN
Fundamental Enterprise Valuation: Free Cash Flow Free Cash Flow (FCF) is the amount of money that can be paid out (or needs to be paid in) to a business as it implements a specific business strategy. In contrast to Earnings, which measures what the business can produce at its current scale, Free Cash Flow measures what the business can produce under a specific plan of growth and capital investment. In the eyes of FMV investors, positive FCF is “thrown off” by a business, and negative FCF is “absorbed” by the business. Positive FCFs are thus available for purposes not included in the business plan, such as payment of interest or dividends, repayment of debt, repurchases of stock, or acquisitions. Negative FCFs are shortfalls, which must be funded raising new debt or equity. The Fundamental Market Value of an Enterprise (FEV) equals the sum of its Free Cash Flows discounted at an appropriate cost of capital: FEV =
FCF1 FCF2 FCFT + 2 +" T ; (1 + k a ) (1 + k a ) (1 + k a )
(1 )
where FCFt is the Free Cash Flow Flow received at time t. If a company has no debt in its capital structure, the appropriate cost of capital to use in this calculation is k a obtained from the Capital Asset Pricing Model: ka = rf + β a (rM – rf ) ;
βa is the (systematic) risk of the business;
rf is the risk-free rate; rate; and (rM – rf ) is the market market risk premium. premium. If a company has debt in its capital structure, the weighted average cost of capital (WACC) may be substituted for ka in equation 1. Alternatively, under the APV method of valuation, the present value of interest tax shields may be added to the sum of FCFs discounted at k a. ________________________________________________________________________________________________________________ Professor Carliss Y. Baldwin prepared this note as the basis for class discussion. Copyright © 2000 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, 02163, or go to http://www.hbsp.harvard.edu. http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.
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801-126
Fundamental Enterprise Valuation: Free Cash Flow
The FEV of a particular business is calculated by projecting its FCFs, and discounting them by an appropriate cost of capital. The FEV of a corporation is calculated by computing the FEVs of each of its businesses, estimating “Excess” Cash in the corporation (if any), and adding up these figures: Corporate FEV =
Σ Business FEVs
+ “Excess” Cash .
The Fundamental Market Value of an Enterprise (FEV) is, by definition, the highest amount that an FMV investor would be willing to pay to acquire the enterprise, including all its outstanding debt and equity. The actual market value of an enterprise may be greater than its estimated FEV if: •
The enterprise has additional valuable opportunities or property (e.g., real estate or patents) not included in the projections; or
•
The capital markets are overvaluing the enterprise relative to what FMV investors would be willing to pay for it.
Conversely, the actual market value of an enterprise may be less than its estimated FEV if: •
Some of its FCFs are being (or will be) diverted so that they don’t reach the investors (for example, the enterprise’s managers may be planning to make unprofitable acquisitions); or
•
The capital markets are undervaluing the company relative to what FMV investors would be willing to pay for it.
Time Pattern of Free Cash Flows Free Cash Flows will be negative if the business is growing faster than its current ROIC (see the note on ROIC in this series). Hence FCFs are usually negative during the high-growth, ramp-up stage of a business. As growth slows, FCF turns positive, and grows with revenue. Finally if a business shrinks in an orderly fashion, FCFs will be positive, but will decline as the business declines.
A Shortcut Free Cash Flow in a given year equals the change in cash balances plus or minus changes in the Debt and Equity accounts. This in turn leads to the following formula: FCF • ∆ Cash and Marketable Securities
(2)
+ Cash Interest Paid + Cash Dividends Paid + Debt Repaid + Equity Repurchased (The formula is only an approximation, because there may be discrepancies in the tax accounts. Such discrepancies are usually minor, however.) If a company has no debt; pays no dividends; and is not repurchasing equity, then the last four terms in equation 2 will be zero. In that case, one can estimate the company’s FCFs by looking at the year-to-year changes in its Cash and Marketable Securities accounts. This can be a quick and useful shortcut.
2
This document is authorized for educator review use only by Shveta Singh, Indian Institute of Technology - Delhi (DMS) until July 2015. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860
