Free-Cash-Flow Valuation
Discounted cash flow (DCF) values a firm as the present value of its free cash flow (FCF), the cash left after operating costs, taxes and the reinvestment needed to sustain the business. This is deliberately a cash measure, not an accounting one. Free cash flow differs from net income because it adds back non-cash charges such as depreciation and subtracts real capital spending and working-capital changes, per the house convention of separating cash-based from accounting-based figures. An analyst builds pro-forma forecasts of FCF, discounts them at the cost of capital, adds a terminal value, and compares the total with the market price.
Why it matters
Net income is an accountant’s opinion shaped by accrual rules. Free cash flow is the money you could actually take out of the business without starving it. A firm can post healthy profits yet bleed cash if it must constantly reinvest, which is exactly why valuation rests on FCF rather than earnings. The hard part is the pro-forma forecast and the terminal value, which often carries most of the final number, so its assumptions deserve the most scrutiny.
Formulas
Worked examples
Reconcile cash from earnings. A firm reports EBIT of A$100m, a 30 percent tax rate, depreciation of A$20m, capital expenditure of A$35m, and a A$10m rise in working capital. What is free cash flow, and why does it differ from net income?
After-tax EBIT is A$100m times 0.70, which is A$70m. Add depreciation of A$20m, subtract capital expenditure of A$35m, and subtract the A$10m working-capital increase. Free cash flow is 70 plus 20 minus 35 minus 10, which is A$45m. This sits well below an earnings-style figure because real reinvestment of A$35m and A$10m tied up in working capital are cash that left the business, while the A$20m depreciation that depressed accounting profit never moved any cash.
Common mistakes
- ✗Net income equals cash flow. Net income includes non-cash charges and excludes capital spending and working-capital swings, so it routinely differs from free cash flow, sometimes dramatically.
- ✗Depreciation is a cash outflow in the FCF calculation. Depreciation is a non-cash accounting charge, so it is added back. The genuine cash use is capital expenditure.
- ✗The terminal value is a minor detail. The terminal value often accounts for the majority of a DCF, so its growth and discount-rate assumptions dominate the result.
- ✗A profitable company cannot have negative free cash flow. A fast-growing, profitable firm can post negative FCF for years if reinvestment and working-capital needs outrun operating cash.
Revision bullets
- •DCF values a firm as the present value of its free cash flow
- •FCF is a cash measure, deliberately distinct from accounting net income
- •Add back non-cash depreciation, subtract CapEx and working-capital changes
- •Build pro-forma forecasts, discount at the cost of capital, add a terminal value
- •The terminal value often dominates the final valuation
- •A profitable firm can still show negative FCF while reinvesting heavily
Quick check
In a free-cash-flow calculation, depreciation is added back to after-tax operating profit because it
Why can a company with positive net income still have negative free cash flow?
Connected topics
Sources
- Brailsford, Heaney & Bilson (2015), Ch. 13Brailsford, T., Heaney, R., & Bilson, C. Investments: Concepts and Applications. 5th ed. Cengage Learning Australia, 2015.Presents discounted cash flow valuation and the construction of pro-forma cash-flow forecasts.
- Bodie, Kane & Marcus (2021), Ch. 18Bodie, Z., Kane, A., & Marcus, A. J. Investments. 12th ed. McGraw-Hill Education, 2021.Reference treatment of free-cash-flow valuation and its distinction from earnings-based measures.