What is free cashflow to the firm? 

Free cashflow means cashflows generated by a company in excess of all its operating and investing needs. It’s not free in the sense of “costless”, rather it’s available for distribution to capital owners, or for re-investment in the business.

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A standard way of valuing companies is to discount their estimated future cashflows, often referred to as doing a discounted cash flow or DCF valuation. There are two parts to this: i) forecast the cashflows; and ii) estimate the discount rate. 

Of these, i) is by far the most work, requiring a lot of knowledge, analysis and judgement. What we’re trying to get at is called the free cashflows to the firm. What does this mean? 

By firm, we simply mean company or corporation. These words are pretty interchangeable, and it’s a bit of a mystery why we sometimes say firm and sometimes company or corporation. 

Free means surplus or available for distribution to capital providers

So what about free cashflows? 

Free has more than one meaning in everyday useage, but here we mean free in the sense of surplus or available, not free in the sense of costless. 

The idea of cashflow is that companies (or firms) have revenues and expenses, some of which involve direct cashflows, and some of which, like depreciation, do not. We only care about actual cashflows, so we adjust for any non-cash items in the expenses or revenues. These non-cash, or accrual, items mainly exist in the accounting measure of profits in order to allocate or spread large items like capital spending over the years for which the items will have value. So we might buy a new machine this year but allocate the costs over ten years, by depreciating it over ten years. The actual cash cost appears all in one year, but the accruted or depreciated cost in the accounts is allocated over ten years, as that is the useful life of the asset. This separation between actual cashflows and accrued costs makes sense if we want to understand what one year’s profits are compared with another. 

But in financial economics, the value of any asset or liability is determined by its actual cashflows. So when doing a discounted cashflow (DCF) valuation, we take only cash revenues and cash costs, including of course taxes.

We also need to deduct any investments (“capital spending or capex”) that the company has made to maintain or grow the business, and any changes in working capital, since these are uses of cashflow that are necessary to keep the company running. Any cashflow left over from all of these is called free cashflow to the firm.

Free cashflow to the firm may be positive or negative in any one year, but obviously needs to be positive in at least some years for the firm or company to have any overall value. Negative free cashflow sounds bad, but may result from a year of higher than usual capital spending. If this is a good use of cashflow and is expected to generate higher operating cashflows in future, then it is a good thing, and the value of all of the future cashflows will be positive. In general, you should not judge a company on a single year’s cashflows.

Free cashflow then, refers to any surplus cashflow, after taking account of all the cashflows needed to run and maintain the business. This can be thought of as cashflow that could be distributed to outside investors, or used to make additional, new investments, without any harm to the value of the company. 

Free cashflow to the firm is different from, but consistent with, free cashflow to equity

These cashflows are not the same as the cashflows that appear in the cashflow statement, because they don’t take account of any debt service costs. There is a related concept which is free cashflow to equity – this is the cashflow remaining after we have deducted the cashflows needed to service the debt holder, or any other claims on the business. If there is anything left, it can be treated as “belonging” to the equity shareholders.

In calculating free cashflow to the firm, we are treating the firm as debt-free, or unlevered, at this point. If we discount these free cashflows at the appropriate cost of capital, derived from the capital asset pricing model framework, then we have an estimate of the value of the whole firm or company, on an unlevered or debt-free basis. This is also called the firm value or enterprise value. If the company does have debt, we need to deduct the value of that debt to get the value of the equity. 

You can use the free cashflow to equity approach and it should give exactly the same result, but it’s easier to use free cashflow to the firm and this is the typical valuation approach used in practice. It’s often helpful to keep separate two questions: i) what is the value of the business as an operating entity, ignoring the way it happens to be financed (ie the capital structure); and ii) what is the appropriate capital structure, given the nature of the operating assets? In public equity (valuing companies that are listed on stock exchanges, the capital structure, meaning the amount of debt relative to equity, is just whatever it is, you can’t change it. In private equity, the owners or potential owners can and often do change the capital structure, so it’s helpful to keep this aspect separate.

Directors decide what to do with free cashflow

Any surplus cashflow, after paying for debt service, belongs, in principle, to the equity shareholders. The actual use of these cashflows in any year is at the discretion of the directors of the company. They may decide to pay out this surplus cashflow, perhaps in dividends or share buy-backs. Or they may decide to keep it in the firm, in case new investment opportunities arise.  But if the directors keep piling up cash in the firm without any obvious use, they are likely to come under criticism, as that cash has an opportunity cost to shareholders, which is the return they could get on it in alternative uses.

So the valuation of the discounted free cashflows to the firm gives us the value of the company, on an unlevered basis. We need to adjust this value by deducting any debt or other obligations that the firm has (such as tax liabilities, environmental liabilities or any other claims on the company’s cashflow that must be paid before the shareholders have their claims). We are then left with the equity value of the company, that is the value of the shareholders’ ownership interest in the firm. 

This approach, or “recipe”, is very widely used and will produce answers that are as good as the assumptions that go into the forecasts. It’s important to restate that the forecasting of the cashflows is the hard part, and that’s where an analyst’s time and effort should go.