6. DCF (Discounted Cash Flow) Valuation
Discounted cash flow (DCF) valuation views the intrinsic value of a security as the
present value of its expected future cash flows. When applied to dividends, the DCF
model is the discounted dividend approach or dividend discount model (DDM). Our
coverage extends DCF analysis to value a company and its equity securities by
valuing free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).
Whereas dividends are the cash flows actually paid to stockholders, free cash flows
are the cash flows available for distribution to shareholders.
Unlike dividends, FCFF and FCFE are not readily available data. Analysts need to
compute these quantities from available financial information, which requires a clear
understanding of free cash flows and the ability to interpret and use the information
correctly. Forecasting future free cash flows is a rich and demanding exercise. The
analyst’s understanding of a company’s financial statements, its operations, its
financing, and its industry can pay real “dividends” as he or she addresses that task.
Free cash flows provide an economically sound basis for valuation.
7. Analysts like to use free cash flow as the return (either FCFF or FCFE)
whenever one or more of the following conditions is present:
• The company does not pay dividends.
• The company pays dividends, but the dividends paid differ significantly
from the company’s capacity to pay dividends.
• Free cash flows align with profitability within a reasonable forecast
period with which the analyst is comfortable.
• The investor takes a “control” perspective. With control comes
discretion over the uses of free cash flow. If an investor can take
control of the company (or expects another investor to do so),
dividends may be changed substantially; for example, they may be set
at a level approximating the company’s capacity to pay dividends.
Such an investor can also apply free cash flows to uses such as
servicing the debt incurred in an acquisition.
8. FREE CASH FLOW (FCF)
• Free Cash Flow (FCF) is calculated after accounting for non-cash
expenses, changes in operating assets and liabilities, and capital
expenditures, free cash flow is the quantum of cash flow generated
(net of taxes) by a company. Simply put, free cash flow refers to the
funds that remain after all payments, investments, and other
obligations have been met. The monies left over for distribution among
stockholders, bondholders, and investors are referred to as free cash
flow.
• Because they exclude substantial capital expenditures and changes in
cash owing to changes in operating assets and liabilities, Free Cash
Flow is a more accurate indicator than EBITDA, EBIT, and Net
Income. Non-cash expenses are also included in measurements like
EBIT and Net Income, which further distorts the view of the underlying
cash flow of a company.
9. FCFF & FCFE
After paying off cash operating expenses and capital expenditures, FCFF is the
cash flow available for optional pay-out to all investors in a corporation, both equity
and debt. FCFF is also referred to as an unleveraged cash flow because interest
payments and leverage effects are not taken into account when calculating it.
FCFE, on the other hand, is a type of discretionary cash flow that is solely available
to a company’s stockholders. After all financial obligations and capital requirements
have been met, this is the remaining cash flow. In order to calculate FCFE, interest
payments or loan repayments are taken into account.
Investors have traditionally focused on indicators such as EBITDA and net income
when appraising equities. While these measures are important for trading
comparisons, the free cash flow (FCF) employed in the discounted cash flow
approach (DCF) is a more accurate assessment of corporate profitability. FCF
differs from operating EBITDA, EBIT, and net income in that it excludes non-cash
expenses and subtracts the capital investment required to maintain the business.
FCF has also gained traction as a viable alternative to the dividend discount model
of valuation, particularly for non-dividend generating companies.
10. FCFF(FREE CASH FLOW FOR FIRM)
• After operational and investing expenses are paid, free cash flow is the amount of money
available to investors. Free cash flow to the firm (i.e., FCFF) and Free cash flow to equity
(i.e., FCFE) are two different forms of free cash flow measurements used in valuation.
We usually refer to FCFF when we speak of free cash flow (FCF). Operating EBIT is
normally adjusted for non-cash expenses as well as fixed and working capital
investments to arrive at FCFF.
• FCFF = Operating EBIT – Tax + Depreciation or Amortization (non-cash expenses) –
Fixed capital expenditures – Increase in net working capital
• Alternatively, FCFF = Cash flow from operations (taken from cash flow statement) +
Interest expense adjusted for tax – Fixed capital expenditures
• FCFF = Net Income + Interest expense adjusted for tax + non-cash expenses – Fixed
capital expenditures – Increase in net working capital
• Thus, FCFF stands for free cash flow for the firm and it is a financial performance metric
that looks at the amount of cash created by a company after all expenses, taxes,
changes in net working capital, and changes in investments have been taken into
account.
• After all other outflows have been controlled and paid, the FCFF is the amount that is
dispersed to the firm’s stockholders and bondholders. Calculating the FCFF is necessary
for any business because it serves as a tool for measuring its profitability and financial
stability. If the FCFF has a positive value, it means the company has a surplus after
expenses are stripped away; if the FCFF has a negative value, the company is in danger
of not having enough revenue to cover expenses or investments[1].
11. FREE CASH FLOW FOR EQUITY (FCFE)
• FCFE is a term that stands for free cash flow to equity and it indicates the amount that is distributed to
equity shareholders once all expenses, changes in net working capital, debt repayments, etc. are
decreased and new loans are added.
• The calculation of FCFE is important since it will aid in determining the firm’s value. FCFE is often
used by experts to assess the value of a firm or company, and it can be used in place of dividends for
this objective. When FCFE is used in stock valuation, this is demonstrated. Instead of dividends, as in
the dividends discount model, the FCFE model of stock valuation uses free cash flow to equity to
value stock.
• We arrive at enterprise value whenever we apply DCF using FCFF by discounting the cash flows with
the weighted average cost of capital (i.e., WACC). Because FCFF considers the complete capital
structure of the company, the costs of all sources of capital are included in the discount rate.
• This cash flow, i.e., FCFE is also known as levered cash flow because it includes the impact of
leverage. As a result, if the firm’s primary source of capital is common equity, its FCFF and FCFE are
likely to be equal.
• But when we use the FCFE model to construct a DCF, we discount the cash flows with the cost of
equity to arrive at an equity value. Because FCFE is the amount left over for only equity shareholders,
only the cost of equity is treated as a discount rate.
• Normally, FCFE is calculated after adjusting the post-tax operating EBIT of a company in respect of
non-cash costs, interest expenses, capital investments, & net debt repayments.
• FCFE = Operating EBIT – Interest – Tax + Depreciation or Amortization (non-cash expenses) – Fixed
capital expenditures – Increase in networking capital – Net debt repayment
• Alternatively, FCFE = Cash flow from operations – Fixed capital expenditures – Net debt repayments +
New debt
12. Important Points Related To FCFF And
FCFE
• In the marketplace, both FCFF and FCFE are popular options. Following are some of the
important points related to them:
• FCFF indicates the value remaining out for all of the firm’s investors, including
bondholders and shareholders, whereas FCFE denotes the amount left over for the firm’s
common equity holders only.
• FCFF ignores the effect of leverage because it does not include the financial obligations
when calculating residual cash flow, and is hence also referred to as unleveraged cash
flow. On the contrary, FCFE is referred to as levered cash flow since it considers the
impact of leverage by removing the net financial liabilities.
• In the DCF valuation, FCFF is used to compute enterprise value or the firm’s entire
intrinsic value. Similarly, in the DCF valuation, the FCFE model is used to calculate the
equity value or the intrinsic value of a company that is available to common equity
shareholders.
• To maintain consistency in considering all capital sources for enterprise valuation, FCFF
is combined with a weighted average cost of capital while doing DCF valuation. FCFE,
on the other hand, is used in conjunction with the cost of equity to ensure that only
common equity shareholders’ claims are taken into account.
• When presenting their activities, management of highly leveraged organizations likes to
employ FCFF. It is necessary to verify that the company does not have a negative
levered free cash flow as a result of large financial obligations, as this could make the
organization unsustainable in the long run.
13. Conclusion
• FCFF is the firm’s free cash flow generated from operations after all
capital expenditures essential for the firm’s survival have been paid
out, and the cash flow is available to all capital providers, including
debt and equity. Because it does not account for financial obligations
of interest and principal repayments at the time of computation of cash
flow, this indicator implicitly eliminates the impact of the firm’s financial
leverage. As a result, unleveraged cash flow is also a term used to
describe it.
• FCFE is the free cash flow available only to common equity
shareholders of a company, and it takes into account the impact of
financial leverage by deducting all the financial liabilities from the cash
flow. As a reason, it is also known as leveraged cash flow. By
deducting tax-adjusted interest expenditure and net debt repayments
from FCFF, FCFE may be easily calculated.
15. Scenario analysis
• Scenario analysis is the process of estimating the expected value of a
portfolio after a given change in the values of key factors take place.
Both likely scenarios and unlikely worst-case events can be tested in
this fashion—often relying on computer simulations.
16. SCENARIO ANALYSIS
The what-if scenario analysis is a project management process that
evaluates different scenarios to predict their effects – both positive
and negative – on the project objectives.
This is one of the modelling techniques used in the Develop Schedule
process.
What-if analysis is used to explore and compare
various plan and schedule alternatives based on
changing conditions.
It can be applied in the primary project phases to try
out scenarios and optimize your plan. During
execution, it is an important tool used to predict the
consequence of any event (late delivery etc.)
17. What-If Scenario Analysis
• What-if scenario analysis can range from a simple
evaluation of the effects of changing the duration of
one or more activities to a more complex analysis.
This could include introducing duration uncertainty,
running project forecasts based on performance-to-
date, all the way to a schedule and cost risk
analysis, taking identified project and enterprise
risks into account.
• The majority of questions asked are exploratory in
nature and are intended to examine the results of
predictions in the future.
18. • What if the Debt & Equity percentage differs & its
impact on net profit?
• What if lead time for major equipment or components is
extended?
• What if we sub-contract parts of the prefab or
fabrication work?
• What if we need to extend the duration of certain
engineering activities?
• What is the effect on completion date and resources if
the current performance trend continues?
• What if prefabrication work seven days a week instead of
five?
• What if we accelerate the schedule?
• The questions often involve making changes to data,
running the analysis, examining the predictions,
comparing it to the schedule, and then challenging the
effect.
19. Benefits of What-If Scenario Analysis
1. Evaluation of Possible Outcomes
A project manager can use WISA to see how a given outcome
might be affected by changes in particular variables.
This provides them with greater insight into the possible
uncertainties they're likely to encounter and the impact
of these risks on the successful completion of the
project.
2. Better Informed Decisions/Actions
Thanks to what-if analysis, project managers can make
more informed decisions about the future of the project,
reducing uncertainty. They can respond to alternative
situations more quickly and effectively because they've
developed strategies to minimize the impact of change.
20. 3. Improved Project Predictability
A what-if scenario is informal speculation about how a given
situation might be handled. The more questions that are asked,
answered, and reviewed throughout each stage of the project
lifecycle, the more informed the project manager, and the more
predictable the project outcome.
4. Analysis of Simple and Complex Factors
WISA is an umbrella term for a type of evaluation that measures the
effect on a project outcome should one of the primary elements be
changed. At its most complex, Monte Carlo analysis can be utilised
to provide analysis throughout unlimited scenarios. To answer basic
questions, a simpler method of what-if analysis can also be used to
extract the necessary information more rapidly.
5. Improved Project Management
What-if analysis allows project managers to recognize options and
impact from events and changing assumptions. With proper
utilization, project managers can make more informed decisions and
predict the outcome of those decisions more accurately.
Project management will always be characterized by a degree of
uncertainty, changes, impact from events, and deviation from the
plan. The challenge is managing each factor and understanding its
impact on the project.
21. Managers typically start with three basic scenarios:
• Base case scenario – It is the average scenario, based on
management assumptions. An example – when calculating the net
most likely to be used are the discount rate, cash flow growth rate,
• Worst case scenario – Considers the most serious or severe
outcome that may happen in a given situation. An example – when
present value, one would take the highest possible discount rate
cash flow growth rate or the highest expected tax rate.
• Best case scenario – It is the ideal projected scenario and is almost
always put into action by management to achieve their objectives.
calculating the net present value, use the lowest possible discount
possible growth rate, and the lowest possible tax rate.
22. What are the Drawbacks of Scenario Analysis?
• Requires a high level of skill – Scenario analysis tends to be a
demanding and time-consuming process that requires high-
• Unforeseen outcomes – Due to the difficulty in forecasting what
may occur in the future, the actual outcome may be fully
in the financial modeling.
• Cannot model every scenario – It may be very difficult to
envision all possible scenarios and assign probabilities to them.
understand that there are risk factors associated with the
consider a certain amount of risk tolerance in order to be able
goal.