Vauling a stock

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chinni234

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I am reading one of the technique of discounted cash flow to find price of stock. If Free cash flow is used, it says expected rate as Weighed average cost of capital (WACC) as your discount rate.

Since free cash flow is obtained with net income and net income is result of subtracting interest expense(debt), Free cash flow should not include any claims against debt holders. I am not sure why WACC is used. I thought Free cash flow is generated for Preferred and common stock holder.

Book says the following
"In this model, you are deriving the value of total firm because you are discounting the operating free cash flows prior to the payment of interest to the debt holders but after deducting funds needed to maintain the firm's asset base(capex). Also because you are discounting the total firm's operating free cash flow you would use WACC as discount rate".


Thanks
 
I'll try to answer this the best way I can.
Ok i think you first need to make a distinction between "OPERATING free cash flows" and "free cash flows to equity". if it's the former simply use the WACC as the discount rate and if it's the latter just use the cost of equity. I hope this helps.
 
Investopedia defines OCF as EBIT + Depreciation - Taxes. Clearly they're not taking out interest, so you would use this to determine total enterprise value by discounting at wacc. (To determine equity value, subtract debt from the result.)

I don't recall seeing the term "operating free cash flow", just OCF. I think it's a bit confusing becuase, as you indicate, the FCF phrase usually means interest has been taken out.

To further confuse it: on the statement of cash flows, I think CFO (cash flow from operations) has interest taken out of it. So CFO is an equity flow, while OCF is an enterprise flow.
 
chinni234, interesting thread. This is Level II material, but as kguizo said, you can distinguish between free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). The former is discounted at WACC, the latter at Ke. I'm confident LI is concerned only with FCFF.

You'll be using these for equity valuation in the same fashion that you're learning to use the dividend discount model at LI.

Some quick definitions courtesy of Schweser's 2007 LII, Book 4, p.123:

"Free cash flow to the firm (FCFF) is defined as the cash flow generated by the firm's operations that is not required to be reinvested for the firm to continue to operate at its current level. Free cash flow to equity (FCFE) is the cash available to stockholders after funding capital requirements, working capital needs and debt financing requirements."

Here are some examples of how to calculate these, which you don't need for your exam but may help demonstrate what's discussed in the quote above.

A quick guide to abbreviations:
NCC = non-cash charges; Int = interest expense; FCInv = fixed capital investment; WCInv = working capital investment; Dep = depreciation.

FCFF (from NI) = NI + NCC + [Int(1-t)] � FCInv � WCInv
FCFF (from EBIT) = [EBIT(1-t)] + Dep � FCInv � WCInv
FCFF (from EBITDA) = [EBITDA(1-t)] + (Dep*t) � FCInv � WCInv
FCFF (from CFO) = CFO + [Int(1-t)] � FCInv

FCFE (from FCFF) = FCFF � [Int(1-t)] + Net Borrowing
FCFE (from NI) = NI + NCC � FCInv � WCInv + Net Borrowing
FCFE (from CFO) = CFO � FCInv + Net Borrowing
 
Thanks for the replies. It will help to remember free cash flow formulas
 
> It will help to remember free cash flow formulas

If you can do that you're in good shape.

I never could memorize lots of similar but slightly different formulas, so if you're like me you might want to understand the underyling concepts instead (so that given a handful of numbers you can derive whatever you need on the fly). Pay attention to whether you're trying to tally flows to all investors (enterprise) or just equity holders. The most confusing thing for me is when to take tax out, or when to add it back if you're working back up the income sheet.
 
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