Free cash flow
The only number in a valuation that is actually cash.
Every discounted valuation is a forecast of free cash flow, so the definition you choose determines what your answer means. There are two, they are not interchangeable, and each pairs with exactly one discount rate and produces exactly one kind of value. Free cash flow to the firm is what the operating business generates before deciding how it is financed; discounted at WACC it gives enterprise value. Free cash flow to equity is what remains after lenders have been paid; discounted at the cost of equity it gives equity value directly. Mixing them is the single most common technical error in valuation, and it is always in the same direction: it inflates the answer.
What this course covers
- 01Start from operating profit, not net income
- 02Tax the operating profit
- 03Add back non-cash charges
- 04Subtract reinvestment
- 05Decide whether to go on to FCFE
What you will be able to do
- FCFF when comparing businesses with different capital structures
- FCFF when leverage will change materially over the forecast: an LBO target, a deleveraging story
- FCFE for banks and insurers, where interest is operating revenue and an unlevered figure is meaningless
- FCFE when you want equity value directly and the capital structure is stable
- Either, when you want to know whether reported earnings are backed by cash
Where it does not apply
- Neither, for a company with no revenue: the forecast becomes an invention
- FCFF where debt is inseparable from operations, as in financial institutions
- Any version, over a single year of a cyclical business, without normalising
Predict it first
Not markedThe plan is revised to fund a new production line. Revenue, margins and the discount rate are all unchanged; the company simply spends more on fixed assets each year.
ChangeCapex: 5.0% → 8.0% of revenue
How this prepares you for the assessment
This is one of 17 courses, and none of them is required for the Verified Valuation Assessment. The credential is earned on two timed drills, graded by the same engine that checks this course, and the drill score decides what it says you are capable of, from Foundation through to Distinction.
- Distinction90%+Works independently across all three core methods.
- Merit75%+Builds the core models with limited supervision.
- Pass60%+Understands the mechanics; works through a model with guidance.
- FoundationcompletedKnows the vocabulary and the shape of each model.