Many ways exist for companies to measure their performances. And one of those ways involves calculating the present value (PV) of free cash flow (FCF), or PV of FCF.
Generally, free cash flow refers to the money a business generates after deducting money for expenses that are spent on non-current capital assets or capital expenditures. A company can distribute these earnings as dividends, use them to pay creditors, or reinvest them in business growth and expansion.
Its formula is:
Free Cash Flow = Cash Flow from Operations (CFO) - Capital Expenditures (CapEx)
When calculating FCF, you will exclude the company’s income statement non-cash expenses, such as amortization and depreciation, but include the balance sheet’s working capital changes as well as money spent on assets and equipment.
It’s from the free cash flow that the present value of free cash flow comes in.
The Present Value of Free Cash Flow
There is just one problem with the free cash flow metric: What the company owes will continue to diminish its capital’s value with time and so will inflation, since the value of money now is much more than it will be in the future.
As a result, people tend to use the present value of free cash flow, which is an adjusted amount obtained by discounting the company’s cash by its weighted-average cost of capital (WACC). The latter represents what a business requires to finance its operations while paying off what it owes annually.
The formula for WACC is:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T)), where:
- E = market value of the company’s equity (market cap)
- D = market value of the company’s debt
- V = total value of company capital (equity plus debt)
- Re = cost of company equity (required rate of return)
- Rd = cost of company debt (yield to maturity on existing debt)
- T = tax rate
Typically, the bigger the debts a company has, the lower the present value of free cash flow it will also have. Also, if you must wait longer to receive your future monies and use a higher discounted rate, your present value will decrease.
Therefore, the present value of free cash flow can be defined as the current value of a future cash flow stream based on a specified rate of return. Those future cash flows are usually discounted at a specified discount rate that you must accurately determine right from the start.
The formula for PV of FCF is:
Expected or Free Cash Flow / ((1+Discounted Rate)^{ Number Of Periods})
How to Calculate the PV of FCF
Below are the steps you could take to calculate the present value of free cash flow.
- Check All the Information: First, find out all the information you need by obtaining the company’s statement of cash flows for the capital expenditure information, income statement for the depreciation and amortization as well as net income, and the balance sheet for the working capital changes.
- Calculate the FCF Value: Second, calculate the free cash flow value. You can obtain it by deducting operating costs and taxes from your sales revenue. Alternatively, you could subtract the net investment in operating capital from your net operating profit after taxes. Be sure to use the company’s financial statements to get these figures. For example, suppose Herbal Inc. has cash flow from operations totaling $1.375 million and capital expenditures worth $0.75 million. In that case, the free cash flow is $625,000 or $0.625 million.
- Determine the Discount Rate: To determine the discount rate, research the company’s WACC or calculate it. You can achieve the latter using the formula given above. Based on our stated example, Herbal Inc. has a WACC of 7.5 percent which is compounded once annually.
- Consider the Time: Determine how long in the future you want to base your calculations. For this case, we could assume a one-year period.
- Use the PV for FCF Formula: Use the formula of PV for FCF to calculate the present value of free cash flow. When doing calculations for Herbal Inc., you could calculate as follows: PV of FCF = $625,000/ ((1+0.075)^{1}), which is like $625,000/1.075 resulting in $581,395.35. You could always use an online calculator to make work easier.
The answer you get is your present value of free cash flow that guides your future investment decisions.
If you want to use a longer period in your calculations, you must perform the calculations for all the years, depending on the expected free cash flows for those years and then find the sum.
For example, suppose you expect free cash flows of $650,000 in the second year and $675,000 for the third year. In that case, you will get a present value of $562,466.20 in year two and $543,348.38 for year three. Therefore, your total present value would be $1,687,209.93. You could comfortably sell your business today for that sum.
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I hold a BS in Computer Science and have been a freelance writer since 2011. When I am not writing, I enjoy reading, watching cooking and lifestyle shows, and fantasizing about world travels.