Free Cash Flow (FCF)

Free cash flow (FCF) is the cash flow a firm has remaining from its operating cash flows after accounting for its capital expenditure and working capital requirements. It is calculated by subtracting the cash used forCapital Expenditure(CapEx) and working capital requirements fromCash Flow from Operations(CFO).

Theunlevered free cash flow(UFCF) does not account for the payment to debt holders whereaslevered free cash flow(LFCF) considers all debt-related financial commitments (i.e. interest and principal payment on bonds). Therefore, UFCF measures the cash flow available to both equity and debt holders while LFCF measures FCF available only to the shareholders of the firm.

A firm could use the FCF in 2 different ways; retain it in the business or pay it out to the shareholders. The decisions on whether to retain or pay out the FCF is known as payoutpolicy in corporate finance.

Some of the reasons that a firm would want to retain FCF include:

• Having the opportunity to invest in potential positivenet present value(NPV) project in the near future
• 建立自己的现金储备times of financial slack when they need to make sure that they are able to meet their payment obligations

Therefore, firms that retain FCF are likely firms that have a highreturn on investment (ROI)or unstable cash flows.

A firm may pay out its FCF in two different ways, namelystock buybacksanddividend payments. In the US stock market, stock buybacks have been the dominant way of returning shareholder wealth by a mile since the introduction of Rule 10B-18 in 1983 which legalized stock buybacks. This is because stock buyback is a more tax-efficient way of returning shareholder wealth compared to dividend payments.

Free Cash Flow formula

There are multiple methods to derive the FCF (UFCF & LFCF) of a company. These methods are related to one another and can be derived from the3 statements(损益表,balance sheet&cash flow statement).

The most common way to calculate the UFCF of a company is as follow:

UFCF=EBIT* (1 - tax rate) +D&A-Change in NWC-Capex

where:

• EBIT=Earnings before Interest and Taxes,
• D&A=DepreciationandAmortisationexpenses
• Changes in NWC= Changes in net working capital
• Capex= Capital expenditure

EBIT,D&AandTaxescan be found in the income statement whilechanges in NWCandCapexcan be found in the current & prior period'sbalance sheet.

The most common way to calculate the LFCF of a company is,

LFCF=Net Income+D&A-Change in NWC-Net investment in operating capital

Free Cash Flow yield (FCF yield)

FCF yield is a financial solvency ratio of a company. It has been touted by some investors to be a better measure of company performance thanearnings per sharedue to the emphasis on the cash flow statement over the income statement in this metric.

FCF yield can be defined in two ways

1. FCF yield = FCF per share / Market Value per share
2. FCF yield = FCF / Market Capitalization

The latter is usually employed as FCF can be found on the cash flow statement andmarket capitalizationcan be easily found using databases such as Bloomberg or FactSet. On the contrary, the former method requires the discovery of theshares outstandingof a company and information regarding shares outstanding may be dated or inaccurate if the company is thinly traded or has buyback schemes.

Some investors may view FCF yield as a better measure of company performance because they believe it is a more accurate representation than earnings per share. This is because FCF yield, unlike earnings per share, considers the financial health of the company (i.e.liquidity) and gives an idea of the accessibility to cash from operations in cases of unexpected obligations. Further, the ability to yield cash flow is a better indicator of long-term value than paper profitability.

The lower the yield, the less attractive a company is to investors as this suggests that theshares are tradingat a higher market value per share despite not generating a superior cash flow to justify it.

在反对的trary, a high FCF yield would suggest the valuation of the company is attractive as the company is generating enough cash flow to satisfy debt obligations and possible increases in dividend payments or buyback schemes. This would lead to an increase in return for the investors should thevaluation multiplesfor the shares increase.

Free cash flow to equity (FCFE)

TheFCFEis a measure of how muchfree cash flowis attributed to the shareholders after all expenses, including those related to CapEx, and financing activities. It is another word for Levered Free Cash Flow (LFCF).

LFCF is usually compared directly to the market value of equity as it considers cash available only to the equity holders of a firm. For example, it is used in thelevered DCF我thod of valuation. In a levered DCF, the appropriate discount rate would be thecost of equity, which is the rate of return required by the shareholders for the level of risk they are undertaking.

Given this, comparing a highly levered firm to one with lower leverage but with identical cash flows, we would observe that the market value of equity would be lower compared to the firm with lower leverage as the cost of equity would be higher, following the assumptions proposed by theModigliani-Miller proposition II.

Negative FCF

Further, alevered FCFhas a higher probability to be in the negative as compared to theunlevered FCFin the same period. This is possible in years where debt repayment obligations amount to more than the unlevered FCF generated by the business.

If the unlevered FCF is negative, the firm has a high growth rate requiring heavy capital expenditure or is making a loss from its ordinary course of business. This would suggest that the firm would need capital injections sooner or later from investors to make up for the negative cash flow, and in cases where it is not due to high growth, it may make sense to sell or restructure the business.

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To continue learning and advancing your career, check out these additional helpfulWSOresources:

• Retained Earnings
• Fraud Triangle
• Accounts Receivable Turnover Ratio
• Marginal Cost Formula
• Nash Equilibrium