1. The Weighted Net Present
Free Cash Flow Final Value
Average Cost of Value of Free
Estimation (FCF) Estimation
Capital (WACC) Cash-Flows
Chapter 3 - Free cash flow (FCF) , final value and terminal value estimation
3.1 How are FCF calculated?
Free Cash Flows to the Company (FCFC) are an important feature a company’s valuation analysis. A Free Cash Flow forecast, as the name indicates,
represents the cash that the company is expected to generate in future. As with any security, the value of a share can be estimated, subject to certain
adjustments, as the discounted value of the cash flows that the underlying asset (i.e. the company’s operations) are expected to generate. As a result, the
majority of financial analysts consider the discounted value of Free Cash Flows as the most accurate estimate of a company’s true worth. The starting
point of any company valuation thus consists in obtaining Free Cash Flow projections.
Equation 1. Free Cash Flow to the Company
Free Cash Flow to the Company =
EBITDA1
 Earnings Before Interest, Taxes, Depreciation and Amortisation are usually calculated in the company’s annual or quarterly reports by
the company.
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The EBITDA (Earnings Before Interest, Taxes Depreciation and Amortization) is increasingly being replaced by the acronym EBITA, as depreciation
is considered as a marginal line item under IFRS (International Financial Reporting Standards) rules.
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2.  If the company report does not report EBITDA, the analyst will add EBIT (Operating Profit, sourced from the company’s Profit &
Loss account or Income Statement) and Depreciation & Amortisation (sourced from either the Profit & Loss or the Cash Flow
account).
(-) Taxes
 The marginal Corporate Tax rate of the country of operations should be applied to EBIT.
 Varies according to the countries.
 When valuing a company present in several countries, the DCF will result from a Sum-of-the-Parts. In this case, the cash flows from
each country will be discounted separately and the relevant tax rates for that country will apply.
(-) CAPEX (Capital Expenditures)
 This represents investment into fixed tangible or intangible assets.
 Sourced from the Cash Flow Statement.
 Capex depends on the type of investments made by the company and it varies for each case and sector. Analysts usually distinguish
between maintenance and expansion Capex.
 In principle, Capex should be equal to Depreciation/Amortisation at the end of the projection period, so they tend to cancel out. This is
relevant for the calculation of the Final Value. This is a standard assumption which can be adapted to a company’s particular
circumstances (for example, for maintenance Capex in industrial companies)
(-) Net Working Capital (NWC)
Working capital is a less intuitive and often overlooked aspect of a company’s operations and valuation. Working capital can be defined as the amount
of financing that a company needs in order to operate under normal commercial conditions. Companies selling products or services will usually accept to be paid
following a certain period of time. While consumers are expected to pay for goods and services immediately, in practice companies selling to other businesses
will accept to be paid following a certain period of time – usually 30 or 60 days. Similarly, a company’s suppliers will usually accept settlement after a certain
period of time. This will usually result in a net need for cash year-on-year (as sales are of a higher value than purchases) which is a component of free cash flow
calculation.
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3.  Working Capital can be calculated by subtracting a company’s total current liabilities from its total current assets.
 The Change in NWC is the annual change in the Working Capital.
 While NWC is a static figure sourced from a balance sheet, the change in net working capital is a flow and therefore more appropriate
to FCFC calculations.
 An increase in Net Working Capital corresponds to a use of cash and therefore will reduce the FCFC while a decrease in Net Working
Capital is a source of funds, which will increase FCFC.
3.2 How is the EBITDA Determined?
The EBITDA was a given value in determining the FCFC, but how is it determined in the company? It is defined as the Revenues (or Operational
Revenues) minus Operational Expenses. Expenses can be classified as Operational (raw materials, employee salaries and related costs, etc.), Capital (CAPEX,
normally costs related to infrastructure, equipment) and Financial (including interest payments). The two latter classifications of expenses should not be included
in the calculation of the EBITDA. Similarly EBITDA should not include exceptional revenues and costs. If determined correctly, the EBITDA should be equal to
Revenues minus Operational Expenses. EBITDA can therefore be seen as the net amount that a company would gain if it only had productive activity and no
financial operations.
Common errors in EBITDA calculation
It is crucial that the EBITDA figure is correctly determined. Mistakes often compromise the accuracy of the projections and the analysis as a whole.
Subtracting Capex when calculating EBITDA is a frequent mistake, which means that Capex is deducted twice in the analysis, resulting in an under-estimation of
the company’s value. A second(and related) mistake is to include Research and Development Expenses as operating costs.When a company developsa new
product line or invests in the improvement of existing products, those expenses will impact the company’s revenues or cost basis for a number of years.
Accordingly, R&D Expenses are treated in a similar way to capital expenses and should not be considered in EBITDA calculation. Rather, R&D Expenses
should be treated in the same way as Capex.
When making projections, the analysis should include the effect of inflation on the projected cash costs; otherwise this will result in expanding margins
and create the illusion of profit.
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4. Finally, operating leases should not be classified as an expense when calculating EBITDA. Leases are financial transactions, and the corresponding
expenses should be taken into account in net debt calculation. The appropriate technique consists in capitalising operating leases and considering this amount as
debt (which is, in turn, deducted from the Enterprise Value to reach Equity Value).
3.3 What are a Company’s Key Performance Indicators?
The DCF method has, among others, an important feature that adds value to the analysis that consists on the transition from building projections based
on financialforecasts(such as growth rates) to start using operational indicators.
While SMEsusuallyproduce a limited amount of financial and operating information for management purposes, larger companies generate a large
amount of such data. Quoted companies almost always invest in Enterprise Resource Planning (ERP) systems, which support the retrieval and electronic
reporting of key financial and operating figures. As a result, a wealth of information in the form of Key Performance Indicators (KPIs) is available to those that
have access to those systems. Using those KPIs for financial modelling is one of the key advantages of implementing ERP systems. From the point of view of the
external analyst with limited access to company information, a number of KPIs are usually included in the company’s filings.
KPIs depend on the sector and company. Some examples of performance indicators are:
The most basic yet useful application of KPIs in valuation analysis is to decompose revenues into quantities and average prices. This can also be applied
to cost analysis. This methodology is valid across sectors. Recent developments in financial markets, where valuation mistakes were made involving complex
financial products, highlight the crucial role that KPIs play in any model. Using the right KPIs and producing a model that is detailed enough yet understandable
and flexible, is one of the key challenges of valuation analysis.
3.4 Calculating FCFC: a critical approach
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5. To put in practice the DCF method and start calculating Free Cash flows to the Company, we use the financial projections of a European industrial company. The
Management Team discloses the projections in the following table, which corresponds to the period 2011 to 2016 plus a final year. The last full fiscal year is
2011 (hence the label “A”, for actual) and the rest are estimates (hence the label “E”).
Table 1 - Calculating FCFC
Unit 2011A 2012E 2013E 2014E 2015E 2016E Final Year
Revenues (R) EUR M 14,525 15,251 16,014 16,654 17,321 17,840 18,375
Change % 0.0% 5.0% 5.0% 4.0% 4.0% 3.0% 3.0%
EBITDA EUR M 1,655 1,906 2,402 2,498 2,598 2,676 2,756
Margin % 11.4% 12.5% 15.0% 15.0% 15.0% 15.0% 15.0%
Net Profit (NP) EUR M 595 686 720 832 866 892 1653
Margin % 4.1% 4.5% 4.5% 5.0% 5.0% 5.0% 9.0%
Net Debt (ND) EUR M 2,616 3,012 3,795 3,947 3,697 3,447 3,147
Change % 15.1% 26.0% 4.0% -6.3% -6.8% -8.7%
Capex EUR M 500 450 450 325 325 325 325
% of D&A % 145% 131% 131% 94% 94% 94%
Change in Net Working Capital
(NWC) EUR M 266 254 191 64 67 26
% of Change in Revenues % 35% 25% 10% 10% 5%
The objective is to produce a revised set of assumptions that better reflect the real prospects of the company. While a credible set of assumptions can
only be produced based on detailed market, product and cost knowledge, you are asked to provide a first critical reading of the estimates produced by the
management team.
The following table presents a number of questions that can be raised by the analyst based on these projections. The first step was to request the
management team to disclose an additional two years of historical data (2009A and 2010A), which are relevant for the critical analysis.
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