Forecast Free Cash Flows

In this article, we are going to discuss the first step of Discounted Cash Flow (DCF) Analysis:

  1. Forecast Free Cash Flows: If you have read the previous article on various models in DCF then you will know that there are many models in DCF valuation like: FCF, DDM, EVA, APV or Residual Income, but most of the time FCF model of DCF valuation is used.

So under FCF model, there are two approaches

  1. Free Cash Flow to Firm (FCFF)
  2. Free Cash Flow to Equity (FCFE)

We have to forecast FCFF or FCFE where FCFF model is more frequently used because it considers total Free Cash flow of firm, not just equity cash flows.

FCFF = EBIT * (1 – Tax rate) + NCC +/- change in WC – CapEx on PP&E

FCFE = PAT + NCC +/- change in WC – CapEx on PP&E +/- Change in Debt

FCFF or FCFE should be forecasted for an explicit forecast period which can be for a min 5 to max 10 years.

Less than 5 will very less and more than 10 years of projection will be too long.

So we should try to keep cash flow projection near to 7 years. Sometimes when you are not able to take a relevant forecast period, then you can download the research report prepared by any Big Investment Bank and from that research report you can source your projection period and even cash flows and assumptions.

Forecast FCF

Free Cash Flow to Firm is also known as Unlevered Free Cash Flow.

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