Free Cash Flow
The cash a company generates from operations after reinvesting in working capital and routine capital expenditure — the figure a DCF valuation projects for about five years and discounts at WACC.
In plain language
Profit is an accounting opinion; cash is a fact. A company can report a rising profit and still be short of money, because the profit includes non-cash charges and ignores the cash it keeps having to put back into stock, receivables and machinery just to stand still.
Free cash flow is what is left after that. The workbook's DCF method is "based on finding the present value of the free cash flow of a company by discounting such cash flow at its weighted average cost of capital (WACC)". Free cash flow is computed for a forecasting period of about 5 years, and a perpetual terminal value is added after that.
The word free is doing the work: free of the reinvestment the business needs to keep running. Anything the company has to spend to maintain its assets and fund its working capital is not free.
How it works
Step one — operating cash flow (section 11.6):
OCF = PAT + Depreciation ± Non-cash charges in the P&L account ± Changes in working capital
If there are reinvestment requirements in fixed assets, these are netted out from OCF to arrive at free cash flow from operations.
What the workbook adds back and takes out.
- Depreciation and amortisations are added back because they are non-cash items in the P&L.
- Changes in working capital are a deduction or an addition depending on whether net working capital has increased or decreased during the year.
- Capital commitments — the normal, minimum capital expenditure to keep fixed assets in working condition — are deducted.
- Ongoing capex and working capital investments are called reinvestment requirements. They are subtracted "along with debt repayments (if any on long term account)" from the operating cash flow to arrive at free cash flow.
- Non-operating income is not considered for valuation unless it is inherent to operations, such as interest income or treasury profits.
The workbook's table, Year 1 (Rs lakh):
| Line | Y1 |
|---|---|
| Profit after tax | 1,369.29 |
| + Depreciation | 10.23 |
| + Other amortisations (10% of PAT) | 136.93 |
| Gross free cash flow | 1,516.45 |
| − Changes in working capital | 136.93 |
| − Capital commitments | 2.19 |
| Free operating cash flow | 1,377.33 |
| + Non-operating income | 27.55 |
| Total free cash flow | 1,404.87 |
The Year 1 to Year 5 free cash flows (Rs 1,404.87 to Rs 2,606.17 lakh) discounted at a WACC of 11.35% have a present value of Rs 6,935.04 lakh; the terminal value adds Rs 22,586.53 lakh, giving an enterprise value of Rs 29,521.57 lakh.
For start-ups (Annexure 11.1), extrapolating free cash flow is hard, so the forecasting period is generally shorter, say 3 years.
A worked example
Illustrative figures. A PE fund is projecting Year 1 for Coimbatore Pumps Pvt Ltd (Rs crore):
| Line | Rs crore |
|---|---|
| Profit after tax | 50.0 |
| + Depreciation | 8.0 |
| + Other non-cash charges | 2.0 |
| − Increase in net working capital | 6.0 |
| − Normal capital expenditure | 9.0 |
| Free cash flow | 45.0 |
Reported profit was Rs 50 crore; the cash genuinely free was Rs 45 crore.
Now suppose a large dealer order means receivables jump and net working capital rises by Rs 30 crore instead of Rs 6 crore. Profit is unchanged at Rs 50 crore, but free cash flow falls to 50 + 8 + 2 − 30 − 9 = Rs 21 crore. A valuation built on profit would not notice; a DCF built on free cash flow would cut the value.
The reverse also happens. If working capital decreases by Rs 4 crore as old receivables are collected, the change is an addition: 50 + 8 + 2 + 4 − 9 = Rs 55 crore.
Why NISM asks about it
Chapter 11 (Valuation) builds the whole DCF method at 11.6 on free cash flow — Step 1 is "Free Cash Flow during the Forecasted Period" — and its business valuation overview at 11.4 describes the income approach as using future expected earnings "to measure the Free Cash Flow of the company". Annexure 11.1 adapts it for start-ups. Expect the OCF formula, the treatment of depreciation and working capital, and the length of the forecasting period.
Common exam traps
- Depreciation is added back; capital expenditure is deducted. They are not the same line and do not cancel.
- An increase in working capital reduces free cash flow; a decrease adds to it.
- About 5 years of explicit forecast for an established company; say 3 years for a start-up.
- In this workbook, free cash flow starts from PAT, not from operating profit, and debt repayments on long-term account are also subtracted — yet the result is discounted at WACC and debt is deducted afterwards to reach equity value. Learn the computation as the workbook sets it out.
- The workbook says non-operating income is excluded unless inherent to operations, but its worked table adds non-operating income (at 2%) to reach total free cash flow. Follow the table for computations; quote the rule if asked what is normally excluded.
- Discounted free cash flow gives enterprise value, not equity value. Outstanding debt is deducted afterwards.
Where this is taught
- Series XIX-A · Chapter 11: Valuationintroduced here
- Series XIX-C · Chapter 14: Valuationintroduced here
- Series XIX-E · Chapter 12: Valuationintroduced here
Related terms
- Discounted Cash FlowA valuation method that estimates the cash a business will generate in future years and converts each year back to what it is worth today.
- Enterprise ValueWhat it would cost to buy the whole business — market capitalisation plus debt, less cash — as opposed to market capitalisation, which buys only the equity.
- Free Cash Flow to FirmThe cash a business generates before any payment to any provider of capital — discounted at WACC it gives the value of the whole firm, from which debt and other claims are then subtracted.
- WACCThe blended after-tax rate a company pays on all its capital, equity and debt weighted by how much of each it uses — and therefore the discount rate for free cash flow to the firm.
- Equity ValueThe value of 100% of a company's shares — what belongs to equity shareholders after debt and preference capital are deducted from enterprise value. For a listed company, its market capitalisation.
- Terminal Growth RateThe constant rate at which free cash flow is assumed to grow forever after the explicit forecast period — the "g" in terminal value = FCF(T+1) / (WACC − g). In young companies it can drive most of the value.
- Operating Cash FlowCash actually generated by a business's core operations — profit after tax with non-cash charges added back and working capital movements adjusted, before any capital expenditure.
- Specific Company Risk PremiumAn extra slice added to the discount rate for one particular company, on top of beta and the market risk premium, to price the unsystematic risk that the CAPM does not capture.