A company can post record net income and still be a poor buy. Free cash flow asks the harder question: after the tax bill and the reinvestment bill are paid, how much cash is actually left for the people who supplied the capital?
Discounted cash flow (DCF) valuation sets intrinsic value equal to the present value of expected future cash flows. Applied to dividends it is the dividend discount model (DDM). Applied to free cash flow it splits into two streams defined by who has a claim on them.
Free cash flow to the firm (FCFF) is the cash available to all suppliers of capital (bondholders, preferred holders, common shareholders) after operating expenses and taxes are paid and after the necessary investment in fixed and working capital is made. Because FCFF belongs to every capital provider, discount it at the weighted average cost of capital (WACC) to get total firm value, then subtract the market value of debt to get equity.
Common mistakes
- Using reported working capital. Subtracting all current liabilities from all current assets pulls cash and notes payable into WCInv. In Example 1, leaving a $30 million notes payable increase in the calculation would move FCFF from $140 million to $170 million.
- Adding interest back pretax. Adding the full $60 million instead of $45 million overstates FCFF by the tax shield. Add back Int(1 − t) whenever WACC is computed on an after-tax basis, and keep the two definitions consistent.
- Double-counting depreciation from EBITDA. From EBITDA only Dep(t) is added, $30 million in Example 1, not the full $120 million. Adding the full amount inflates FCFF by $90 million.
Bottom line
- Pairing rule: FCFF discounts at WACC and gives firm value; FCFE discounts at the cost of equity and gives equity value directly
- From net income: FCFF = NI + NCC + Int(1 − t) − FCInv − WCInv; FCFE = NI + NCC − FCInv − WCInv + Net borrowing
- Bridge: FCFE = FCFF − Int(1 − t) + Net borrowing; from CFO, FCFF = CFO + Int(1 − t) − FCInv
- From EBIT: EBIT(1 − t) + Dep − FCInv − WCInv; from EBITDA: EBITDA(1 − t) + Dep(t) − FCInv − WCInv
Exam shortcut
Before touching numbers, write the pairing on your scratch sheet: FCFF with WACC then subtract debt, FCFE with and stop. Half the wrong answers in a free cash flow vignette are the correct arithmetic run through the wrong discount rate or with the debt subtraction applied to an FCFE result. Read the stem for the starting line. "Net income" means add NCC and after-tax interest.
The full lesson (about 4,114 words, 27 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- free cash flow valuation
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