FCF - What is free cash flow and how do I calculate it A...

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What is free cash flow and how do I calculate it? A summary provided by Pamela Peterson Drake, Florida Atlantic University CONTENTS: Estimates of cash flows .................................................................................................................... 1 Free cash flow ................................................................................................................................. 2 Free cash flow and agency theory .................................................................................................. 3 Free cash flow to equity ................................................................................................................ 3 Free cash flow to the firm .............................................................................................................. 3 Valuation using free cash flow ........................................................................................................... 4 Example .......................................................................................................................................... 5 Issues ............................................................................................................................................. 6 Online resources for additional information on free cash flow ............................................................... 6 The value of a company requires estimating future cash flows to providers of capital and capitalizing these to determine a value of the company today. But what are these cash flows and how do we estimate them? Estimates of cash flows Cash flows have been estimated a number of ways, which adds to the confusion about how we should value a company. Consider the simplest form of cash flow, which is the earnings before depreciation and amortization , EBDA . This cash flow is sometimes referred to as the accounting cash flow because before we had the statements of cash flow or the older, funds flow statement, EBDA was often used as a quick estimate of cash flow. The calculation is simple and only requires information from the income statement: (EQ 1) EBDA = Net income + depreciation + amortization In the EBDA, we are adding the primary non-cash expense that had been deducted to arrive at net income. If we are valuing a company, however, we must consider that the cash flow should be that available to the suppliers of capital – i.e., creditors and owners. Because interest is deducted to arrive at net income, what we need is a cash flow before any interest. This then provides an estimate of cash flow that could be paid to both creditors and owners. This cash flow is referred to as earnings before interest, depreciation, and amortization , or EBITDA : (EQ 2) EBITDA = Net income + interest + depreciation + amortization Also known as … Analysts look at a company’s EBITDA because this enables comparison of the results from operations among companies in the same line of business that should have similar operating cost structures. And because it is an earnings number before depreciation and amortization, it is not affected by the method the company chooses to spread the capital costs over the assets’ useful life. However, EBITDA, though EBITDA is also known as operating income before depreciation and amortization, or OIBDA . 1
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useful in some applications, is does not fully reflect the cash flows of a company. The requirement that companies report cash flow information in the statement of cash flows provides information that is useful in financial analysis and valuation. This statement requires the segregation of cash flows by operations, financing, and investment activities. A key cash flow in both analysis and valuation is the cash flow for/from operating activities. This cash flow is calculated by adjusting net income for non-cash expenses and income, as well as for changes in working capital accounts. This latter adjustment is used to convert the accrual-based accounting into cash-based accounting.
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