Chapter 7:  Free Cash Flow Models

n the last chapter, we introduced the dividend model and defined the concept of intrinsic value.  The simple dividend model is very sensitive to the firm’s dividend policy and this sensitivity limits its practical usefulness.  For example, a profitable firm that does not pay any dividends would have a zero value, which is clearly incorrect.  In this chapter we extend the dividend model to a model called the Free Cash Flow to Equity (FCFE) Model.  Conceptually, this FCFE Model refines the concept of a dividend from an accounting dividend, which is dependent upon the firm’s dividend policy and legal restrictions, to the concept of an economic dividend which does not depend upon a firm’s dividend policy.  As a result, this model is applicable to any stock, including non-dividend paying stocks.

The specific learning objectives for this chapter are to understand:

·         Accounting versus Economic Dividends

·         The FCFE Model of intrinsic value

·         How to use Valuation Tutor to work with the FCFE model

·         How to apply the FCFE Model to real world companies

·         How to perform sensitivity analysis on the key drivers to test their reasonableness

·         How to calculate implied expected return using the FCFE model

As discussed in the last chapter, John Williams was one of the first to analyze the intrinsic value of a stock in terms of present value of all future dividends in his 1938.  Williams also appears to be the first to use the concept of free cash flow to value a stock.  In Chapter XXII of his book, titled “United States Steel,” he observed that the company had not paid dividends recently (prior to 1937), but this did not imply that the dividend model could not be applied.

“To estimate the value of Steel Corporation’s stock, we must first estimate its normal quasi-rent, or earnings before depreciation and taxes.  Next we must estimate the reinvestment requirements of the business.  Then we shall find whatever distributable balance is left over after paying property taxes, bond interest, income taxes, and preferred dividends can go to the common stockholders, and will determine the investment value of their stock.”

In the 1980’s, there was a sharp increase in leveraged buyout activity (a leveraged buyout occurs when an entity acquires a controlling interest in a company but borrows money for the purchase).  In any buyout, it becomes important to value the company being purchased, and during this period, the concept of free cash flows became very popular.  For example, Warren Buffet in his 1986 Letter to Shareholders used the term “Owner Earnings” which you can compare to Williams definition given above and the definition we typically use today, given below:

"If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”

The term “free cash flow” was used by Jensen (1986) in his work on agency costs and he defined the term as:

“Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies.”

Formal accounting requirements for cash flow reporting followed a similar path in response to increased attention from financial market participants.  In 1963 the Accounting Principles Board (APB) issued Opinion No. 3 which recommended the inclusion of a statement focusing on investing and financing activities not involving working capital.  In 1971 this type of statement became required with APB Opinion No 19, Reporting Changes in Financial Position.  The modern format of the Statement of Cash Flows emerged in 1987 when the FASB adopted the Statement of Financial Accounting Standard (SFAS) 95.