What Is Free Cash Flow To Equity?

Free cash flow (Free Cash Flow) is a new concept, theory, method and system of corporate value evaluation. After more than 20 years of development, especially the so-called high-performance companies whose financial indicators are flawless in financial reports, such as American Enron and WorldCom, have become the most widely used and theoretically sound indicators in the field of corporate valuation. The SEC even requires that this indicator be disclosed in the company's annual report.

Free cash flow

Free Cash Flow is a

Capital expenditures refer to those expenditures incurred in multiple accounting periods when the benefits of property or labor services are obtained. Therefore, such expenditures should be capitalized, first included in the asset category, and then transferred to the appropriate expense account in stages based on the benefits obtained.

In the business activities of an enterprise, assets that are used for a long period of time and whose economic life will go through many accounting periods, such as fixed assets, intangible assets, deferred assets, etc., should be treated as capital expenditures. That is, it is capitalized to form fixed assets, intangible assets, deferred assets, etc. Then, as the benefits they provide to the business, they are resold to expenses in each accounting period. Such as: depreciation of fixed assets, amortization of intangible assets, deferred assets, etc.

Corresponding to capital expenditures are revenue expenditures, also called period expenses. Article 20 of China's Accounting Standards for Business Enterprises stipulates: "Accounting should reasonably divide revenue expenditures and capital expenditures. Where the benefits of expenditures are related to this fiscal year, they should be treated as revenue expenditures. Related to the fiscal year should be treated as capital expenditures ". Such expenditures should be capitalized, first included in the asset category, and then transferred to the appropriate expense account in stages based on the benefits obtained.

Free cash flow represents the cash that a company obtains and will be free to dispose of. And "freedom" is not rich in cash flow, companies can repay debt, develop new products,

Free cash flow can be divided into the overall free cash flow of the enterprise and the enterprise

With the definition of free cash flow, two expressions are derived:

Cash flow

Free cash flow is the wealth created by the company's continuing operations, and it covers data from three major reports, which are very different from indicators such as profit and cash flow from operating activities. The following is artificial manipulation,

Introduction

The cornerstone of free cash flow valuation is the future free cash flow and discount rate. But its use must have certain assumptions: the company has a positive cash flow when it is valued, and future cash flows can be estimated more reliably, and at the same time, it can determine the appropriate discount rate based on the relevant characteristics of cash flow, then Is suitable to use freedom

Enterprise value and

Free cash flow for the firm is a valuation of the entire company, not the

FCFF model

The FCFF model believes that the company's value is equal to the company's expected cash flow discounted at the company's cost of capital.

Model input parameters

When using the discounted free cash flow model for company valuation, the input parameters that need to be determined mainly include the forecast of free cash flow, the discount rate (cost of capital), and the forecast of the growth rate and growth model of free cash flow.

1) Forecasting future free cash flow

The value of the company depends on future free cash flows, not historical cash flows, so it is necessary to start from the current year to forecast the company's balance sheet and profit and loss statement within a sufficiently long period in the future (generally 5-10 years). This is the most critical step that affects the accuracy of the discounted free cash flow valuation method. It requires forecasters to understand the fundamentals of the company's macro economy, industry structure and competition, company's products and customers, and the company's management level. The company's historical financial data has a deeper understanding and understanding, and is familiar with and grasps the company's operating environment, business operations, products and customers, business models, company strategy and competitive advantages, operating status and performance and other aspects of current status and future development prospects.

Based on the analysis of the historical data of the company and industry, forecast the future development of the industry and products and the company's operations, forecast and evaluate the company's future competitive advantage and positioning in the industry, and the company's sales, operating costs, depreciation Projects such as taxation, taxation, etc., and require forecasters to adopt a systematic approach to ensure consistency in forecasting. Experience and judgment in forecasting are also very important.

2) Cost of capital

Corporate capital can generally be divided into three categories, namely debt capital, equity capital, and hybrid capital. Hybrid capital includes preferred stocks, convertible bonds, and warrants. From an investor's perspective, the cost of capital is the rate of return required by an investor to invest in a particular project, or opportunity cost. From the perspective of the company, the cost of capital is the rate of return on investment that the company must meet to attract capital from the capital market. The cost of capital is determined by the capital market and is based on the capital market value, rather than the book value set by the company itself or based on the book value. Debt and preferred stocks are fixed income securities, and the cost estimation is relatively easy. Mixed types of securities, such as convertible bonds and warrants, can be estimated in two parts because of the built-in options. The valuation of built-in options can be Black -Scholes option pricing formula method and binomial pricing model.

There are many models for estimating the cost of common stock, including: capital asset pricing model (CAPM), arbitrage pricing model (APM), various forms of extended capital asset pricing model, risk factor addition method, FamaFrench three factor model model.

The common points of these models are: all are built on the premise that the securities market is effective, and there is a risk-free benchmark rate of return and a arbitrage-free pricing mechanism; the basic principle is that the cost of equity capital = risk-free income + risk compensation, but risk compensation There are differences in factors and estimates.

The capital asset pricing model (CAPM) is the most widely used equity capital cost stock price model. The traditional capital asset pricing model (CAPM) is based on the assumption that capital markets are efficient, investor rationality, risk aversion, and the degree of portfolio diversification is sufficient and effective Above, therefore, only the compensation system risk factor is considered, and a single is used to reflect the degree of system risk in the securities market.

The formula for calculating the cost of equity capital of a company based on the Capital Asset Pricing Model (CAPM) is:

When US companies estimate the cost of capital, they generally use a market risk premium of 5% to 6%. There are many prediction methods for the beta coefficient. The following three methods are commonly used:

In countries with developed capital markets, there are market service agencies that collect and sort out relevant data and information on the securities market, and calculate and provide coefficients for various securities;

Estimate the historical value of the securities coefficient, and use the historical value to replace the value of the securities in the next period;

The value was estimated by regression analysis.

The cost of debt is the cost of debt borrowed by the company when financing an investment project. The cost of debt is related to the following factors:

Market interest rate level: As the market interest rate rises, the cost of the company's debt will rise accordingly;

The company's default risk: The higher the company's default risk, the higher the cost of debt, and the higher the company's asset-liability ratio, the higher the marginal cost of debt.

Debt has a tax shield effect: Because interest is paid before tax, the cost of debt after tax is related to the tax rate of the company. The higher the company's tax rate, the lower the cost of debt after tax.

The company's weighted average cost of capital calculation formula is:

2 Company value creation from the perspective of free cash flow value model

The company's value is the net present value of the company's expected free cash flow discounted at the company's cost of capital. So free cash flow is the source of the company's value creation. Any management activity and decision of the company must meet one or more of the following four conditions in order to create value for the company:

Increase the cash flow generated by existing assets; increase the expected growth rate of cash flow; increase the length of the company's high-speed growth period; optimize financing decisions and capital structure management to increase the value of the company.