How to Calculate the Present Value of Free Cash Flow
Original post by Sean Mullin of Demand Media
Free cash flow is the capital that remains after a company deducts expenditures and debts from revenue. The company may divide the remaining capital among shareholders as dividends or invest it in future ventures. Future debts and obligations cause capital's value to diminish over time. To create a more accurate measure of capital's investment power, accountants calculate its adjusted "present value." This calculation involves discounting the cash by the company's weighted-average cost of capital, which is the percentage of capital needed annually to pay its obligations and finance its operations. The free cash flows of companies with significant debts and obligations have less present value.
Identify the company's free cash flow by counting the capital assets available for investments and dividends.
Research the company's current weighted-average cost of capital (WACC). Convert the WACC rate into decimal form. Add the decimal form of the company's WACC to the number 1: the resulting number will be between 1 and 2.
Multipy the sum of 1 and the WACC rate exponentially for every year in the future you wish to calculate the present value. In other words, raise the number to a power equal to a number of years in the future. For example, if you want to know the free cash flow's investment value in three years, raise the number to the third power.
Divide the free cash flow by the exponentially-multiplied rate. The result is the free cash's present value for future investments.
- "Equity Asset Valuation"; John D. Stowe, et al.; 2007
- "Financial Management Theory and Practice"; Eugene F. Brigham and Michael C. Ehrhardt; 2010
About the Author
Sean Mullin has been creating content for providers such as eHow since 2007. He also worked in an online writing center for college students. In addition to writing, Sean has a Master of Arts in classics and teaches Greek and Latin part-time at the college level.