The Tale of Free Cash Flow and the Hidden Value

In the prosperous city of Valoria, two thriving businesses—Alpha Tech and Beta Foods—competed not just for customers but also for investors. Both companies had impressive revenue, but wise investors knew that revenue alone wasn’t the best measure of a company’s worth. The real secret lay in Free Cash Flow (FCF).

The Merchant’s Advice

One day, a seasoned investor, Elder Finn, visited both companies to determine which was a better investment. Instead of focusing on revenue or profits, he asked one question:

"After all expenses and reinvestments, how much cash do you truly have left to distribute or reinvest?"

This puzzled the business owners, but they showed him their financial books.

Understanding Free Cash Flow

Free Cash Flow (FCF) = Operating Cash Flow - Capital Expenditures

  • Alpha Tech’s FCF: $5 million
  • Beta Foods’ FCF: $2 million

While both companies were profitable, Alpha Tech had more cash available after covering all expenses. This made it a potentially stronger investment, as free cash flow indicated the real cash a company could use for dividends, share buybacks, or future growth.

The Valuation Approaches

Elder Finn then used three key valuation methods to determine their worth:

1. Discounted Free Cash Flow (DCF) Approach – "The Crystal Ball of Investing"

Elder Finn projected Alpha Tech’s future free cash flows, applying a discount rate (Weighted Average Cost of Capital - WACC) to estimate today’s value of those future cash flows.

Value of Firm=∑FCFt(1+r)t\text{Value of Firm} = \sum \frac{\text{FCF}_t}{(1 + r)^t}

Where:

  • FCF_t = Free Cash Flow in year t
  • r = Discount rate (WACC)
  • t = Future years

By doing this, Finn estimated that Alpha Tech was worth $50 million today, based on expected future cash flows.

2. Free Cash Flow to Equity (FCFE) Approach – "The Investor’s Share"

Instead of looking at the entire firm, Elder Finn wanted to know how much cash was left for shareholders after covering debt obligations.

FCFE=FCF−Debt Payments+New Borrowings\text{FCFE} = \text{FCF} - \text{Debt Payments} + \text{New Borrowings}

Since Alpha Tech had low debt, its FCFE was strong, meaning it could easily pay dividends or reinvest in growth.

3. Free Cash Flow to Firm (FCFF) Approach – "The Company’s True Value"

To value the whole firm, he used:

FCFF=EBIT(1−Tax Rate)+Depreciation−CAPEX−Change in Working Capital\text{FCFF} = \text{EBIT} (1 - \text{Tax Rate}) + \text{Depreciation} - \text{CAPEX} - \text{Change in Working Capital}

This approach helped Finn compare Alpha Tech and Beta Foods regardless of their financing decisions.

The Decision

After analyzing all methods, Elder Finn saw that Alpha Tech had:
✅ Higher Free Cash Flow
✅ A strong Discounted Cash Flow (DCF) valuation
✅ Consistent FCFE, meaning investors would get more returns
✅ A solid FCFF, showing overall company strength

So, he invested in Alpha Tech, confident in its ability to generate real cash for its shareholders.

The Lesson

In Valoria, many investors chased revenue and profits, but only the wise looked at Free Cash Flow, the real indicator of a company’s financial health.

And so, Elder Finn walked away wealthier, proving that those who understand Free Cash Flow Valuation unlock the true hidden value of companies.

[Finance]

Comments

Post a Comment