In the first part of this article series I showed how to value a firm using the market valuation method, where stock prices are used to estimate equity market capitalization.
In this post, I will explain the Free Cash Flow to the Firm (FCFF) method of corporate valuation. The approach is covered in a lot more detail in my textbook, especially Corporate Finance: 2nd Edition, and you can find out much more about the fundamentals of the approach there.
The basis of the FCFF method is Discounted Cash Flow and Time Value of Money. I won’t spend any time discussing this concept here but the interested reader is invited to read any of my textbooks, where I go into this method in depth.
To value a company using the FCFF method, one must first estimate the cash flows that are earned in each year and discount these values to today’s terms.
Step 1: Estimation of Free Cash Flows.
The best way to estimate free cash flows is to work with a company’s management and derive estimates of future cash flows (up to about five years).
However, this isn’t practical in many cases where only the most recent financial accounts are available. In this situation, the easiest way to estimate the cash flows that come into the firm is to use the following formula together with the company’s most recent cash flow statement:
Free Cash Flow to the Firm = Cash Flow from Operations + Cash Flow from Investing Activities
To illustrate, we will continue with our case study of Carillion plc. The cash flow statement of Carillion (taken from the 2013 Annual Accounts) is as follows:
The Free Cash Flow to the Firm in 2013 was thus £107.2 million – £78.4 million = £28.8 million.
At this point, I’d like to state that the massive change in cash flow components between 2013 and 2012 gives me significant concern on the viability of this method in valuing Carillion plc.
This is because we have no way of knowing what is a sustainable cash flow or whether cash flows will settle down in the future.
Keep a look out for cases were the cash flows change significantly from one year to the next. In Carillion’s case, there was a significant disposal of assets (£143.7 million) in 2013 that would unlikely be repeated. However, we don’t know if the cash that was released because of this sale was used to acquire assets in the same year!
Since this post is only to show how to use the FCFF method, we will keep this concern in mind but do nothing to investigate further.
Lets move on to the next steps…
Step 2: Estimate the growth rate in cash flows
A simplifying assumption that I am going to make here is that the FCFF grows at a steady rate forever. Clearly, this is unrealistic. However, it is a good starting point and a Launchpad for more complex analysis later on.
Unfortunately, growth rates are notoriously difficult to estimate as they are based completely on subjective forecasts. My favoured approach is to simply use analyst forecasts as an initial estimate, and iterate further once initial firm values have been calculated.
Looking at the Carillion page on FT.Com (search for the name in the FT.Com website and click on forecasts tab):
Two forecasts are provided for the growth rate: 1.71% and 1.45%.
Looking at earnings figures for the company can also provide some more insight on growth rates (assuming that dividends are paid out as a constant percentage of earnings):
Source: FT.Com, July 2014.
Thus, a third growth rate estimate is 6.53%.
Finally, we can also check Carillion’s annual report to see if they have an estimated growth rate of cash flows. From page 93 of their 2013 annual report:
“The cash flows used to determine the value-in-use calculations are based upon the latest three year forecasts approved by management which are based upon secured and probable orders and the Group’s overall strategic direction. The cash flows are extrapolated from year four, with a terminal value using a growth rate of 2.5 per cent. This growth rate does not exceed the long-term industry average and reflects the synergies from recent acquisitions.”
Step 3: Estimate the discount rate (Weighted Average Cost of Capital or WACC).
The fastest way to find out the Weighted Average Cost of Capital of Carillion is to search Google to see if an analyst has already estimated the figure (sometimes, the company itself will provide the WACC).
From a quick search of the internet, I found this December 2013 report from Saxo Bank (via www.tradingfloor.com) :
The full document can be downloaded here.
The WACC we will go with for Carillion plc is 7.3%
Step 4: Estimate Value of Firm
There are many ways to work with cash flows in discounted cash flow analysis and much of what is calculated comes down to simplifying assumptions. In my analysis here, I am assuming that cash flows will grow at a constant rate forever.
The formula I am using is:
Value of Firm = FCFF(1+g)/(WACC-g) = 28.8(1+g)/(.073-g)
where FCFF = £28.8 million; WACC = 7.3%. We have several growth rates (1.45%, 1.71% 6.53%, 2.5%).
Our estimates of firm value are therefore:
As you can see, they straddle the market valuation method estimate (from Part 1) of £2.7626 billion.
Strengths and Weaknesses:
The Strengths of the Free Cash Flow Method are:
- The method is applicable for all firms (public and private firms) and is useful when the company to be valued has no stock price data.
- The method is tied to the financial accounts of the company and is thus based on audited financial figures.
- It is good for companies with stable cash flows and constant capital structures.
The weaknesses of the method are:
- It doesn’t use stock price information, which is the most timely information.
- It is very sensitive to inputs such as Free Cash Flow Estimates, Growth Rates, and Discount Rate.
Admittedly, the method hasn’t been particularly effective in valuing Carillion plc.
To explore this further, I would definitely attempt to come up with a more refined set of cash flow forecasts. I would also look again at the growth rates we used in this example and identify the most appropriate.
Interested readers can find out how to do this in much more detail in any of my textbooks.
In the next instalment of this article series, I will discuss the Asset Valuation method of corporate valuation.
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