How is free cash flow valuation different from general DCF?

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AcadiFi · Accepted Answer

Discounted cash flow (DCF) is a broad framework: discount any future cash flow stream by the appropriate discount rate. Free cash flow valuation is a specific application where the cash flow measured is either free cash flow to the firm (FCFF) or free cash flow to equity (FCFE), discounted at WACC or cost of equity respectively.

FCFF = operating cash flow after tax + after-tax interest - capex - change in working capital, and represents cash available to all capital providers (debt and equity). Discount FCFF at WACC to get enterprise value, then subtract net debt to arrive at equity value.

FCFE = net income + depreciation - capex - change in working capital + net borrowing, and represents cash available to equity holders. Discount at cost of equity directly for equity value.

For Mervyn Aerospace, FCFF might be $450M next year, $480M year two, growing 3% thereafter. With WACC of 8%, terminal value at year 2 = $480M × 1.03 / (0.08 - 0.03) = $9,888M; plus PV of explicit forecasts; minus $2,000M debt = equity value.

General DCF can apply to any cash stream: dividend discount model (cash flow = dividends), residual income (cash flow = economic profit), real options (cash flow from optionality). FCF valuation is preferred when dividends are not reflective of cash-generating capacity or when capital structure is expected to change (FCFF is capital-structure-neutral).

Key watchpoints: consistency between cash flow and discount rate, terminal value assumptions, and proper treatment of non-operating items.

How is free cash flow valuation different from general DCF?

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