A Finance Tip For Calculating Free Cash Flows To The Firm

During my MBA, Prof David Wessels of Wharton simplified a convoluted idea so elegantly that it hit me like a lightning bolt. Here it is, in case you are interested in finance and valuation.

In valuation, I used to always struggle with calculating the free cash flows to the firm (FCFF). Traditionally, you start with operating profit and then add back depreciation and amortization (to adjust for 'non-cash items'), subtract capex, subtract changes in working capital and other operating items etc.

When you see a real-life financial statement with 20-30 line items, it becomes very confusing.

Prof Wessels gave a simple idea:

Free cash flow to firm (FCFF) = After-tax operating profit (NOPAT) - change in invested capital.

That's it. Done.

Forget about all the adjustments for non-cash revenue/expenses - the balance sheet captures it anyway. Just categorize the balance sheet items as operating and non-operating (make the best guess). And once you have the invested capital, use the formula above and you are done.

Surprisingly, this is also very intuitive. From the profit a business generates, a portion is reinvested - and the rest is your cash flow. What could be simpler?

Use this and you will never, ever go wrong.


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