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    Damodaran Free Cash Flow

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    Kartikay Goswami
    1. The document discusses free cash flow and how it is often misused or misunderstood. Free cash flow refers to the cash left over after a company has spent money required to maintain or expand its asset base. However, it is often conflated with or treated as equivalent to earnings, EBITDA, or other operating performance metrics. 2. The author argues that free cash flow should be properly understood and estimated when using it for specific purposes like explaining past performance, forecasting future cash flows for valuation, or comparing pricing multiples across companies. Simply adding back non-cash expenses to earnings does not give an accurate picture of free cash flow. 3. Examples are provided of properly estimating free cash flow

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    © All Rights Reserved
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    Damodaran Free Cash Flow

    Uploaded by

    Kartikay Goswami
    61 views24 pages
    1. The document discusses free cash flow and how it is often misused or misunderstood. Free cash flow refers to the cash left over after a company has spent money required to maintain or expand its asset base. However, it is often conflated with or treated as equivalent to earnings, EBITDA, or other operating performance metrics. 2. The author argues that free cash flow should be properly understood and estimated when using it for specific purposes like explaining past performance, forecasting future cash flows for valuation, or comparing pricing multiples across companies. Simply adding back non-cash expenses to earnings does not give an accurate picture of free cash flow. 3. Examples are provided of properly estimating free cash flow

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    Damodaran free cash flow (1)

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    1. The document discusses free cash flow and how it is often misused or misunderstood. Free cash flow refers to the cash left over after a company has spent money required to maintain or expand its asset base. However, it is often conflated with or treated as equivalent to earnings, EBITDA, or other operating performance metrics. 2. The author argues that free cash flow should be properly understood and estimated when using it for specific purposes like explaining past performance, forecasting future cash flows for valuation, or comparing pricing multiples across companies. Simply adding back non-cash expenses to earnings does not give an accurate picture of free cash flow. 3. Examples are provided of properly estimating free cash flow

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    61 views24 pages

    Damodaran Free Cash Flow

    Uploaded by

    Kartikay Goswami
    1. The document discusses free cash flow and how it is often misused or misunderstood. Free cash flow refers to the cash left over after a company has spent money required to maintain or expand its asset base. However, it is often conflated with or treated as equivalent to earnings, EBITDA, or other operating performance metrics. 2. The author argues that free cash flow should be properly understood and estimated when using it for specific purposes like explaining past performance, forecasting future cash flows for valuation, or comparing pricing multiples across companies. Simply adding back non-cash expenses to earnings does not give an accurate picture of free cash flow. 3. Examples are provided of properly estimating free cash flow

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    Aswath Damodaran 1

    EARNINGS AND CASH FLOWS: A


    PRIMER ON FREE CASH FLOWS
    Who put the free in free cash flow?
    The Cleansing Effects of a Market
    Correction
    2

    ¨ It is never pleasant to be in the midst of a market


    correction, but a market correction does operate as a
    cleanser for excesses that enter into even the most
    disciplined investors' playbooks in the good times.
    ¨ This correction has been no exception, as the threat of
    losing investment capital has focused the minds of
    investors, and led many to reexamine practices adopted
    during the last decade.
    ¤ There has been more talk of earnings than of revenue or user
    growth this year, and the notion of cashflows driving value
    seems to be back in vogue.
    ¤ I find that development welcome, but I find myself doing double
    takes I see concoctions of free cash flow that violate first
    financial principles.
    Aswath Damodaran
    2
    Free Cash Flow: The Most Dangerous Term
    in Finance
    3

    ¨ Free cash flow is one of the most dangerous terms in finance,


    and I am astonished by how it can be bent to mean whatever
    investors or managers want it to, and used to advance their
    sales pitches.
    ¨ I have seen analysts and managers argue that adding back
    depreciation to earnings gives you free cash flow, an
    intermediate stop, at best, if you truly are intent on
    computing free cash flow.
    ¨ In the last two decades, I have seen free cash flow measures
    stretched to cover adjusted EBITDA, where stock-based
    compensation is added back to EBITDA, and with WeWork, to
    community-adjusted EBITDA, where almost all expenses get
    added back to get to the adjusted value.

    Aswath Damodaran
    3
    Free Cash Flows to whom?
    4

    Aswath Damodaran
    4
    Free Cash Flows to Equity
    5

    Aswath Damodaran
    5
    Free Cash Flow to Firm
    6

    Aswath Damodaran
    6
    FCFE and FCFF: Microsoft

    Aswath Damodaran
    7
    Another way to present free cash flow

    8
    Using Free Cash Flows
    9

    ¨ there are facile reasons that you can give for computing free cash
    flows, including the usual “we don’t trust accounting earnings”
    and “cash is king”, but there are three places free cash flows can
    be used
    ¤ The first is that is that computing free cash flows for a past period helps in
    explaining what happened at a business during that period, in operating,
    investing and financing terms.
    ¤ The second is that it is that the free cash flows that you compute for a past
    period can be used as the basis for forecasting expected free cash flows in
    the future, a key ingredient if you are doing intrinsic valuation.
    ¤ The third is to compute the free cash flow as a base to be used to compare
    pricing across companies, where the market price is scaled to free cash
    flow, rather than to earnings.
    ¨ Since each of these missions has a different end game, there can
    be consequences for how we estimate free cash flows in each one.

    Aswath Damodaran
    9
    1. Explain the past
    10

    Aswath Damodaran
    10
    FCFE and Cash Balances
    11

    Aswath Damodaran
    11
    Reading FCFF
    12

    Aswath Damodaran
    12
    2. Intrinsic Valuation

    13
    Free Cash Flow in Valuation: Base Year
    14

    1. Unusual or Extraordinary items: If you are computing cash flows as a base for forecasting the future, you should eliminate any items
    that you don’t expect to recur in the future.
    2. Normalized vs Actual numbers: For items that are recurring, but volatile, there is a good case to be made that while you will use the
    actual values, if computing free cash flows for the most recent year, you should be normalizing them, though the methods you use for
    normalization can vary across items. With the change in non-cash working capital, a notoriously volatile item on a year-to-year basis,
    - Change in working capital replaced by working capital computed using WC as % of revenues
    - Actual acquisition with average over time.
    3. Stock-based Compensation and Acquisitions: Stock-based compensation is more of an in-kind expense, where you give away shares of
    equity in the company instead of paying cash. If you are estimate free cash flows (to the firm or to equity), with the intent of valuing
    that firm, adding back stock-based compensation is equivalent to arguing that you can either stop paying employees in the future (and
    still hold on to them) or that you can keep giving away equity stakes in your company with no consequences for value per share. Using
    the logic that paying for something with shares, instead of cash, still has an effect on free cash flows, we would argue that a company
    that plans to grow through acquisitions, using its own stock as currency, is reinvesting, and that this reinvestment should reduce
    expected free cash flows to equity, to existing shareholders.
    4. Taxes: When your objective is to forecast future free cash flows. I would suggest looking at an average effective tax rate over a longer
    period, in computing the base year free cash flow, and then also targeting the marginal tax rate, as you forecast taxes for the future. In
    the Microsoft FCFF calculation, this would imply replacing the effective tax rate of 13.83% with an average effective tax rate of 22%,
    using the 2017-2021 time period, which would lower free cash flows to the firm.
    5. Accounting Inconsistencies: While R&D remains a cash outflow, whether you treat it as an operating or a capital expenditure, moving it
    from operating to capital expenditures can alter your perception of a company's operations. In the case of Microsoft, for instance,
    capitalizing the $20,716 million that the company spent on R&D in 2021, will increase the net income for the company, while also
    raising the reinvestment by an equivalent amount.

    Aswath Damodaran
    14
    Microsoft: FCFE for the past versus FCFE as
    a basis for the future
    15

    Aswath Damodaran
    15
    3. Pricing
    16

    ¨ The question of which variants (FCFE or FCFF) can be used depends on


    whether you are using an equity pricing multiple (where the market cap
    or share price is in the numerator) or an enterprise value multiple (where
    it is the market value of operating assets in the numerator):
    • With equity multiples, you can scale the market value of equity (or market
    capitalization) of a company to its free cash flow to equity, to estimate a Price to
    FCFE multiple, and offer it as an alternative to the much more widely used PE ratio,
    where market capitalization is scaled to net income.
    • With enterprise value multiples, you can scale enterprise value to FCFF, instead of
    using EBITDA or revenues as your scalar. Again, you could argue for the benefits of a
    more complete measure of cash flow, but as with FCFE, FCFF will be more volatile
    than revenues or EBITDA, making it difficult to pass pricing judgment.
    ¨ The logic that analysts use for the use of free cash flows is simple and
    seems compelling. If the value of a business is the present value of its
    expected cash flows, as we argue in intrinsic valuation, it seems
    reasonable to also argue that the free cash flow that a business generates
    is a better measure of its value than the accounting earnings.

    Aswath Damodaran
    16
    A Life Cycle Perspective on Free Cash
    Flows
    17

    Aswath Damodaran
    17
    And how it played out at Tesla…
    18

    Aswath Damodaran
    18
    And across companies…
    19

    Aswath Damodaran
    19
    Playing out in dividends & buybacks
    20

    Aswath Damodaran
    20
    Pricing: Cash Flows versus Earnings
    21

    ¨ While there are some cash flow purists who prefer cash
    flow multiples to earnings multiples, they will never be
    widely used for two reasons.
    ¤ No frame of reference: The reason that investors like to price
    companies, using multiples, is because they have frames of
    reference on these multiples, i.e., a sense of what a typical
    number should like like in a sector. With PE ratios, their long
    history of usage has left investors with frames of reference that
    they can use, rightfully or wrongfully, in pricing stocks, but with
    Price to FCFE ratios, there is no such reference frame.
    ¤ Noise in estimates: As you can see from how FCFE is computed,
    with the netting out of reinvestment and incorporating debt
    cash flows, it will always be a more volatile number than
    earnings, with much of the additional volatility telling you little
    about current earnings power.
    Aswath Damodaran
    21
    Perspective on Equity Pricing
    22

    Aswath Damodaran
    22
    Perspective on EV pricing
    23

    Aswath Damodaran
    23
    A Bottom Line on Pricing
    24

    ¨ As a cash flow advocate, it pains me to say this, but if your


    game is pricing stocks, I see little benefit from replacing
    traditional multiples (like PE and EV to EBITDA) with free cash
    flow scaled pricing measures.
    ¨ That is because a single year’s free cash flow (to equity or the
    firm) has more noise in it, and is less informative about a
    company’s operating health, than a single year’s earnings (net
    income or EBITDA).
    ¨ However, you can augment your PE or EV to EBITDA pricing
    by bringing in insights that you get from computing and
    calculating free cash flows including:
    ¤ How much a company pays in taxes
    ¤ How much it reinvests to deliver its growth
    ¤ How much it is adding to or reducing debt

    Aswath Damodaran
    24

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