Free Cash Flow (FCF)

The Foundation of DCF Valuation

What is Free Cash Flow?

Free Cash Flow (FCF) is the cash a company generates after accounting for cash outflows to support operations and maintain capital assets.

FCF represents the cash available to all investors (both debt and equity holders) after the company has paid all operating expenses, taxes, and made necessary capital investments. It's the most important metric in DCF valuation because it shows real cash generation, unlike accounting profits which can be manipulated.

Why FCF Matters: Companies can't pay dividends, buy back stock, or pay down debt without free cash flow. It's the ultimate measure of financial health and value creation.

Two Types of Free Cash Flow

Unlevered FCF (UFCF)

Also called: Free Cash Flow to the Firm (FCFF)

Definition: Cash flow available to all investors (debt + equity) before debt payments

Used for: Enterprise value DCF models (most common)

Levered FCF (FCFE)

Also called: Free Cash Flow to Equity

Definition: Cash flow available only to equity holders after debt payments

Used for: Equity value DCF models (less common)

IntrinsiclyIQ uses Unlevered FCF (UFCF) - This is the industry standard approach for DCF valuation.

The Unlevered Free Cash Flow Formula

UFCF = NOPAT + D&A - CapEx - ΔNWC

Unlevered Free Cash Flow = NOPAT + Depreciation & Amortization - Capital Expenditures - Change in Net Working Capital

Component Breakdown:

NOPAT (Net Operating Profit After Tax)

Formula: NOPAT = EBIT × (1 - Tax Rate)

Alternative: NOPAT = Revenue × Operating Margin × (1 - Tax Rate)

NOPAT shows operating profit after taxes but before financing costs. It's the starting point for FCF because it represents cash from operations.

+ Depreciation & Amortization (D&A)

D&A is added back because it's a non-cash expense that reduced NOPAT but didn't actually use cash.

Critical Point: Depreciation is subtracted in the income statement (reducing net income) but added back in FCF calculation because no cash left the company. This is often missed and causes incorrect negative FCF calculations.
- Capital Expenditures (CapEx)

Cash spent on physical assets like equipment, buildings, or technology. This is actual cash outflow.

  • Growth CapEx: Investments to expand capacity
  • Maintenance CapEx: Investments to maintain current operations
  • Typical range: 3-15% of revenue (varies by industry)
- Change in Net Working Capital (ΔNWC)

Cash tied up in day-to-day operations (inventory, receivables, payables).

Formula: ΔNWC = (Current Assets - Cash) - (Current Liabilities - Debt)

Simplified: ΔNWC = Change in (Accounts Receivable + Inventory - Accounts Payable)

  • Positive change: More cash tied up (reduces FCF)
  • Negative change: Cash released (increases FCF)
  • Typical assumption: 1-3% of revenue for stable companies

Complete UFCF Calculation Example

Company XYZ - Year 1 Projection

Given Information:

  • Revenue: $1,000M
  • Operating Margin (EBIT/Revenue): 20%
  • Tax Rate: 25%
  • Depreciation: 5% of revenue

Assumptions:

  • CapEx: 8% of revenue
  • Working Capital Change: 2% of revenue

Step-by-Step Calculation:

Step 1: Calculate EBIT

EBIT = Revenue × Operating Margin = $1,000M × 20% = $200M

Step 2: Calculate NOPAT

NOPAT = EBIT × (1 - Tax Rate) = $200M × (1 - 0.25) = $150M

Step 3: Calculate D&A

D&A = Revenue × 5% = $1,000M × 5% = $50M

Step 4: Calculate CapEx

CapEx = Revenue × 8% = $1,000M × 8% = $80M

Step 5: Calculate Change in NWC

ΔNWC = Revenue × 2% = $1,000M × 2% = $20M

Step 6: Calculate Unlevered Free Cash Flow

UFCF = NOPAT + D&A - CapEx - ΔNWC

UFCF = $150M + $50M - $80M - $20M

UFCF = $100M

Interpretation: Company XYZ generates $100M in free cash flow available to all investors. This cash can be used for dividends, debt repayment, share buybacks, or growth investments.

Understanding Negative Free Cash Flow

Negative FCF isn't always bad - it depends on the reason:

Good Reasons (Growth Investment)
  • High CapEx for expansion (e.g., Amazon building warehouses)
  • Working capital needs for rapid revenue growth
  • Strategic investments for future cash generation
  • Early-stage companies building infrastructure
Bad Reasons (Structural Issues)
  • Low or negative operating margins (unprofitable)
  • Excessive CapEx without returns
  • Poor working capital management
  • Deteriorating business fundamentals
Key Question: Is the negative FCF temporary and leading to higher future cash flows, or is it structural and ongoing? This determines whether it's acceptable or concerning.

Free Cash Flow vs Net Income

Net Income and FCF often differ significantly. Understanding why is crucial:

Factor Net Income Free Cash Flow
Depreciation Subtracted (reduces net income) Added back (no cash impact)
CapEx Not included (capitalized) Subtracted (cash outflow)
Working Capital Not directly reflected Changes reduce/increase cash
Interest Expense Subtracted Excluded (unlevered)
Manipulation Risk Higher (accrual accounting) Lower (actual cash)
Why FCF is Superior for Valuation: FCF shows actual cash generation, not accounting profits. A company can report profits while burning cash (or vice versa). Cash is what ultimately determines value.

Industry-Specific FCF Considerations

Technology / Software
  • High margins → Strong FCF
  • Low CapEx (5-8% of revenue)
  • Minimal working capital
  • R&D is expensed (not capitalized)
Manufacturing / Industrials
  • Moderate margins
  • High CapEx (10-15% of revenue)
  • Significant working capital needs
  • Cyclical FCF patterns
Retail / E-commerce
  • Thin margins → Lower FCF
  • Moderate CapEx (stores/warehouses)
  • High inventory working capital
  • Seasonal FCF variations

Common FCF Calculation Mistakes

Forgetting to Add Back Depreciation

This is the #1 error. Depreciation reduces NOPAT but isn't a cash expense. Always add it back or your FCF will be artificially low.

Omitting Working Capital Changes

Growth companies need working capital investments. Forgetting this overstates FCF and leads to overvaluation.

Using Levered Instead of Unlevered FCF

UFCF should exclude interest expense. Including it double-counts debt costs (once in WACC, once in FCF).

Unrealistic CapEx Assumptions

CapEx should align with growth strategy. High growth requires high CapEx. Low CapEx assumptions for growing companies are unrealistic.

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