Free cash flow to the firm (FCFF) is the cash flow that a company is ‘free’ to distribute to all providers of money (both, debt and equity) without damaging its growth opportunities. Below I explain the process an analyst would go through to estimate free cash flow.
Like all forecasts, your FCFF starts with your revenue forecast. From this revenue, you subtract operating expenses to arrive at earnings before interest and taxes (EBIT), the operating profit the company generates from its assets. EBIT is the key assumption that impacts the FCFF, hence, the value of the business.
Three providers of resources to run a business
There are generally three providers of resources to run a business: Those investing in a company (equity shareholders), those lending to the company (banks or bondholders), and the government, which provides the company’s license to operate.
Because the government has the right to revoke this license, the company must pay taxes before it pays investors or lenders. So you first reduce EBIT by your estimate of taxes due on this EBIT, which leaves you with net operating profit after tax (NOPAT).
Start with EBIT and estimate Cash NOPAT
Next, since FCFF is a measure of cash flow, not profit, non-cash expense which you previously deducted to arrive at EBIT, should be added back to EBIT. After you add depreciation and amortization to NOPAT, you arrive at a number I call Cash NOPAT.
Your forecast for Cash NOPAT is usually positive; in fact, it should be very positive for most companies. Cash NOPAT is the starting point in free cash flow valuation, the cash flow that the company produces from its existing operating assets.
Calculate the required working capital investment needed
Next, you forecast the annual amount of inventory and accounts receivable that the company must maintain to support your revenue growth forecast. Though we call these current assets, they exist all the time in the business so you could consider them to be more like an investment in working capital. The working capital investment amount each year is only the change in those accounts, not the total outstanding (since the company has already invested the outstanding amount).
But there is good news; suppliers give the company some additional credit each year, which could pay for a portion of that annual increase in inventory and accounts receivable. So we reduce, or ‘net out,’ the change in supplier credit to arrive at the annual change in net working capital. This net change is the amount that the company must invest in working capital or current assets each year to support your EBIT growth forecasts.
Approximate the capital expenditures needed for maintenance and growth
The next step is to estimate the amount that the company will need to invest in long-term assets, often called capital expenditures (Capex). There are two parts to this forecast, Capex to maintain the current assets and Capex for new assets. The combination of maintenance Capex and growth Capex gives the total amount of Capex you expect the business will need to spend to support your EBIT growth forecast.
Subtract the working capital investment and Capex to arrive at FCFF
You then subtract your estimated annual change in net working capital and your estimated annual Capex from the Cash NOPAT to arrive at your free cash flow to the firm for that year. This FCFF is available to both investors and lenders and could be freely paid out as dividend without sacrificing your EBIT growth forecast.