Monday, April 19, 2010

Sustainable FCFF (UFCF)

One of the most important measures of value for a company is Sustainable (Terminal) FCFF so I wanted to review some of the ideas which go into calculating it. As the finance saying goes:
"Turnover is vanity,
Earnings is sanity,
but Cash is reality"
Also, because Terminal Value represents somewhere between 70 to 80% of the calculated Enterprise Value in a DCF, the assumptions that go into developing and FCFF have a major impact on the final valuation.

First a recap of what composes FCFF (a slightly more educated view since my first encounter with this measure on the CFA Level I exam):

FCFF = NI + Dep - WCInv - Capex + Int (1-t)

To build up to FCFF, we
  1. take NI from the Income Statement
  2. add depretiation to get Cash Flow (CF) as a non cash expense (we'll ignore others like change in deferred tax liability for now although for a "sustainable" cash flow they'd net out at 0 anyways)
  3. Subtract Working Capital Investment (change in working capital) to get Cash Flow from Operations (CFO)
  4. Subtract Capex to get Free Cash Flow (FCF)
  5. Finally, since we are looking for cash flows to all stakeholders (including debt holders) we add back the net value of debt after tax to get FCFF

Now let's break down each of these components. First of all, in real terms we'll project zero growth. However, some terms are susceptible to inflation growth (marginal nominal growth).

As a result, even with zero real growth, there will be some marginal incremental growth in WCInv and Capex to reflect this inflation. The best way to model it is as a percentage of sales according to the CFA.

FCFF = NI + Dep - WCInv - Capex + Int (1-t)

Another consideration is dividing up capex along two dimensions - 1. Maintenance capex and 2. Investment capex. Maintenance capex is defined as the capex required to maintain your operations. By definition, it is equal to depreciation. Therefore:

FCFF = NI + Dep - WCInv - [Maintenance Capex + Investment Capex] + Int (1-t)

= NI - WCInv - Investment Capex + Int (1-t)

Also, investment capex is related to expanding to new opportunities. However, again, since we are modeling a "sustainable" cash flow rather than a perpetually growing cash flow, investment capex is 0 by definition. This generates a further interesting result:

FCFF = NI - WCInv + Int (1-t)

Next I'd have a look at WCInv. If WCInv is stable, then it should produce a marginal change in the cash flow.

Note also that FCFF = FCFE + Int (1-t) + Net Principle Repayment

This shows that NI is a decent (though not perfect) proxy for sustainable FCFE and that by tacking on the interest net of tax effect, we can arrive at a good proxy for sustainable FCFF.

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