Free Cash Flow (FCF): What is it?

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 for资本支出(CapEx) and working capital requirements fromCash Flow from Operations(CFO).

The unlevered free cash flow (UFCF) does not account for the payment to debt holders whereas levered 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 payout policy 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

因此，保留FCF的公司可能是拥有高的公司return on investment (ROI)or unstable cash flows.

A firm may pay out its FCF in two different ways, namelystock buybacks和dividend payments。在美国股票市场中，自1983年引入规则10B-18以来，股票回购一直是使股东财富归还一英里的主要方式，该方法使股票回购合法化。这是因为与股息支付相比，股票回购是一种更有税收的退还股东财富的方式。

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(income statement,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=Depreciation和Amortisationexpenses
• Changes in NWC= Changes in net working capital
• Capex= Capital expenditure

EBIT,D&A和Taxescan be found in the income statement whilechanges in NWC和Capexcan be found in the current & prior period's balance sheet.

计算公司LFCF的最常见方法是，

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 the股份发行of 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 the shares are trading at a higher market value per share despite not generating a superior cash flow to justify it.

相反，由于公司正在产生足够的现金流以满足债务义务并可能增加股息支付或回购计划，因此公司的估值很有吸引力，这表明公司的估值很有吸引力。这将导致投资者的回报增加valuation multiplesfor the shares increase.

Free cash flow to equity (FCFE)

TheFCFEis a measure of how much free cash flow is 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 the levered DCF method 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.

鉴于此，将高度杠杆的公司与杠杆率较低的公司进行比较，但与现金流相同，我们会发现，与具有较低杠杆率的公司相比，股票的市场价值将较低，因为股本的成本将更高，遵循假设较高由Modigliani-Miller proposition II。

Negative FCF

Further, a levered FCF has a higher probability to be in the negative as compared to the unlevered FCF in 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.

For more information on how to use FCF in a DCF analysis, do consider taking a look at our DCF modeling coursehere。