3.1.6. Free Cash Flow and Free Cash Flow Yield
Free cash flow is a subset of cash flow and can be used as a measure of both a company’s liquidity and its profitability. Free cash flow is basically the amount of money a company has left over after accounting for operational and capital expenses, depreciation and amortization, and taxes. This money could be reinvested in the business, used to pay debt, or distributed to shareholders.
There are several different ways to compute free cash flow. A fairly standard (but hardly universal) approach is to calculate free cash flow to the firm (FCFF). Free cash flow to the firm refers to the cash that is “free” to pay out to all investors in the firm. This cash flow is available to common stockholders, preferred stockholders, and bondholders. FCFF is often referred to as unlevered free cash flow because it is cash flow before interest on debt is considered. It is calculated as:
FCFF = EBIT (earnings before interest and taxes) × (1 – tax rate) + noncash charges (such as depreciation and amortization) – capital expenditures – increases in working capital*
* Add any decreases in working capital
FCFF can also be calculated from net income using the following formula:
FCFF = net income + noncash charges (such as depreciation and amortization) + interest × (1 – tax rate) – capital expenditures – increases in working capital *
* Add any decreases in working capital
In this equation, the most common noncash charges are depreciation and amortization. Note that in addition to depreciation and amortization, certain other noncash charges may be included in the calculation, such as:
• Restructuring charges
• Loss on the sale of long-term assets
• Increases in deferred tax liabilities that are not expected to reverse
FCFF is the type of free cash flow that is used in a discounted cash flow analysi