How to Calculate Free Cash Flow

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Shanell Henderson
Australia

How to Calculate Free Cash Flow for a Company

The Free Cash Flow (FCF) method is a valuation technique used to determine the intrinsic value of a company by analyzing its projected cash flows. It assesses the cash available to the company's investors, both equity and debt holders, after accounting for operating expenses, capital expenditures, and working capital requirements. Here's an overview of how the Free Cash Flow method works:

Calculate Operating Free Cash Flow: Start by calculating the company's operating free cash flow, which represents the cash generated from its core operations. It is typically derived by subtracting operating expenses, taxes, and changes in working capital from the company's operating income.

Operating Free Cash Flow = Operating Income - Operating Expenses - Taxes - Change in Working Capital

Account for Capital Expenditures: Deduct capital expenditures (CAPEX) from the operating free cash flow. CAPEX includes the company's investments in long-term assets, such as property, plant, and equipment. This step reflects the amount of cash required to maintain and grow the company's operations.

Free Cash Flow = Operating Free Cash Flow - Capital Expenditures

Assess Debt and Interest Payments: If the company has outstanding debt, deduct interest payments from the free cash flow to account for the cash allocated to servicing debt obligations.

Free Cash Flow (to Equity) = Free Cash Flow - Interest Payments

Discount Cash Flows: Apply a discount rate, often based on the company's cost of capital or the required rate of return, to account for the time value of money. This helps determine the present value of the projected cash flows.

The discount rate reflects the risk associated with the investment and represents the rate of return required by an investor to compensate for the risk. The higher the risk, the higher the discount rate.

Calculate Intrinsic Value: The sum of the discounted cash flows represents the estimated intrinsic value of the company. This value represents what the company is worth today, based on its projected cash flows.

It's important to note that the Free Cash Flow method relies on assumptions and projections, making it subject to potential inaccuracies. Additionally, selecting an appropriate discount rate and accurately forecasting future cash flows can be challenging.

The Free Cash Flow method is often used in conjunction with other valuation techniques to gain a more comprehensive understanding of a company's value. It is recommended to consult with financial professionals and consider multiple valuation approaches when making investment decisions.