In a previous article, the basic concepts of DCF valuation such as time value money were discussed (Read more here). This article will focus on basic concept of Free Cash Flow to Firm and Free Cash Flow to Equity (FCFE). There are many ways to compute FCFF and FCFE. For more detail, you can refer to Professor Damodaran’s slides (Read more here). This article will only focus on deriving FCFF and FCFE from Earnings Before Interest and Tax (EBIT).
FCFF is not
something readily available like Price to Earnings (PE) ratio. Investors need to compute FCFF from financial
data (annual or quarterly report), and then forecast the future FCFF based on
their understanding of the company business model, direction, and development.
FCFF can be
interpreted as the cash flow available to all the firm’s capital contributors
such as debtholders, preferred stockholders and common stockholders, without
impacting the firm’s daily operation and future development.
FCFE can be
derived from FCFF. It is the cash flow
available to the firm’s common stockholders after the FCFF has accounted for
payment (and receipts from) debtholders and preferred stockholders.
Mathematically,
FCFF can be computed by
where,
EBIT =
Earnings Before Interest and Tax
Dep =
Depreciation
CAPEX = Capital Expenditure
∆WC =
Changes in Working Capital
The formula
is simple but getting the right numbers to be inserted into the formula is not
straight forward. Thanks to Bursa Market
Place (link), the
official market info portal by Bursa Malaysia.
You can find financial data, technical chart, company rating, research
report, and all other related financial info under one roof. And it is free!
Let’s take
one real world example, Top Glove. The annual
financial reports can be found in the following link.
1.
Annual
Income Statement
a.
Web
View
2.
Annual
Balance Sheet
a.
Web
View
3.
Annual
Cash Flow Statement
a.
Web
View
From the
annual financial statement, the EBIT can be found in income statement on row
Normalized EBIT. Depreciation can be
found in either income statement or cash flow statement, they are the same.
Tax rate, CAPEX, and Changes in working capital are a bit tricky. You need to calculate them from financial statement rather than obtaining them directly. Thanks to Bursa Market Place, you can download the financial statements in excel format and let the spreadsheet do the calculation for.
For tax
rate, you can obtain it by dividing the Provision for Income Taxes with Net Income
Before Taxes. Both can be found in
income statement.
For changes in working capital, it is a bit tricky but still be able to estimate from balance sheet. The information you need are Total Current Assets, Total Current Liabilities, CASH AND SHORT TERM INVESTMENTS, Notes Payable/ Short Term Debt, and Current Port. Of LT Debt/Capital Leases.
Under normal condition, working capital is defined as current assets minus current liabilities. However, for FCFF valuation purpose, we exclude cash and short term debt, please refer to this link for the rational. Working capital can be computed as
Changes in working
capital is simply this year working capital minus last year working capital.For simplicity,
CAPEX can be computed by using this year gross properties, plants, and
equipment (PP&E) minus last year gross PP&E. Please refer to the following link
for detail in estimating CAPEX.
Now you have all the information to compute FCFF. Try to build one using Excel or Google Sheet, and then compare your results with the following embedded Google Sheet. Congratulations! You are one step nearer to build your own DCF model.
Disclosure: The author may have interest in the stocks of the companies in this article.
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