How to Value a Company with Negative Free Cash Flow

A negative sum of discounted FCFF is rare. Usually, forecasts are positive and on top of that, there’s the terminal value.

A negative forecasted cash flow in some years of your projection window shouldn’t stop you from using the DCF model as usual. And you can never ignore negative cash flows in an attempt to make your calculations cleaner.

However, if the model gives you a negative share price or enterprise value? You should use a different valuation method, such as the DDM or relative valuation, or alter your assumptions (forecasted cash flows, take real options into account, or use different discount rates for different cash flows).

That’s the gist of it. Want a more comprehensive answer?

Keep reading:

Understanding Free Cash Flow

The Discounted Cash Flow (DCF) model is a method of valuing a business, project, or asset based on its future cash flows.

In the DCF model, you get a company’s Enterprise Value (EV) by forecasting the Free Cash Flow to the Firm (FCFF) it will generate over a number of years, and then discounting those cash flows to the present using an appropriate rate.

The discount rate reflects the opportunity cost and the risk of investing in the company. The higher the risk, the higher the discount rate.

The free cash flow is composed of two main items:

• Operating cash flow: Start with the net income of the business and add back depreciation (because it is not an actual cash outflow). This is usually positive, but not always. How to proceed when this is negative is the subject of this post.
• Investment cash flow: Subtract capital expenditures and changes in working capital, as these are actual cash flows.

You calculate this for each forecasted year, then discount those values to the present, and then sum it all up together to get the enterprise value of the company.

You sum all discounted free cash flows in your projection window—whether they are positive or negative.

Never ignore negative cash flows and focus only on positive ones, as this means you will overvalue the business.

On the last year of the forecasted period, you’ll want to estimate the terminal value—which is the value of the company beyond the forecast period, calculated either using a multiple or assuming a perpetual growth rate on the last year’s free cash flow.

The terminal value is generally the most significant component of the enterprise value of a business.

Thus, a DCF model with a negative free cash flow at some point in the projection window will not necessarily result in a negative EV.

In these cases, there is no problem using the DCF model to value the business.

But when EV you get from the DCF model is negative, you should use alternative valuation methods.

You will usually see negative EV (sum of all discounted FCFF) in companies with consistent negative operational cash flow and high investments.

We will look at the DCF alternatives below, but first? Let’s understand why a company may have negative cash flow from operating activities and how it hampers valuation:

Reasons for Negative Cash Flow from Operating Activities

Negative cash flow is when cash outflows exceed cash inflows in a given period. They reduce the value of a company or project, as they indicate lower returns and/or higher risks.

Here are three main reasons why a company can have negative cash flow from operating activities:

• Life cycle: It’s common for companies to be unprofitable at the start of their life cycle. Even mature companies can face temporary setbacks that lead to negative cash flows for a number of years. Also, some industries require huge infrastructure investments upfront and companies will lose money until everything is ready.
• Temporary problems: Economic downturns, failed investments, or difficulties in the overall industry the company operates in will enable a cash flow problem.
• Too much debt: Increased leverage means increased interest expense, which the firm has to pay immediately or else it risks defaulting on its financial obligations and damaging its creditworthiness.

There’s also inefficient cash management.

Having low negotiation power with clients means the company receives payments later rather than sooner. Increased accounts receivable lead to negative cash flow—as the income statement recognizes any sale as revenue, even if the cash is yet to be received.

The same applies to suppliers. If a company has to pay its operating expense to suppliers fast, more cash flows out of the business.

But this won’t be reflected in the operating cash flow. Instead it goes to Working Capital Changes within the investment cash flow when computing the FCFF.

Now, how do negative earnings make valuing a company harder?

Because you will make more uncertain assumptions.

Negative net income and cash flow make it difficult to estimate the perpetual growth rate to use for the terminal value of the company.

When earnings are negative, applying a growth rate will make them even more negative.

It also makes it difficult to estimate taxes. When firms lose money, they can carry the net operating loss forward and pay less taxes in the future when they’re profitable.

Additionally, it puts the main assumption of the DCF model (with terminal value) in jeopardy—that the company will stay in business indefinitely.

Negative free cash flow overall is not necessarily a bad thing though. It can mean investment cash flow surpasses operating cash flow.

And if the company has a high Return on Invested Capital (ROIC)? Negative FCFF due to investment outflows is a great thing.

It means the company is investing everything it can in high-return projects to increase its profitability.

Still, this is usually temporary.

When FCFF is negative for a lot of back-to-back years with no hopes of revenues scaling free cash flow to become positive, that is a bad sign. A sign of serious cash flow issues.

So, how do you value a company with negative earnings or cash flow?

Negative DCF Valuation

As we’ve seen, not all companies have positive net income.

Some businesses are unprofitable to begin with, while others could have positive earnings but still negative free cash flows.

As we’ve seen, companies with negative cash flows are harder to value than companies with positive cash flows.

You can still use the DCF model to value a company with negative cash flows as long as those cash flows are estimated to become positive at some point in the future.

Simply treat all cash flows the same, whether they’re negative or positive, by discounting them to the present. And then sum all cash flows together. That is your EV.

But what happens if all forecasted years in your DCF model have negative free cash flow?

Negative NPV and enterprise value. This is bad. There are more negative cash flows than positive ones.

But it isn’t necessarily wrong. A company (or any asset) that is expected to only generate negative cash flows is worthless. In fact, you should be paid to have it.

This is because an asset is nothing more than the right to future cash flows (whether they’re interest payments, dividends, or capital gains). And if the present value of those cash flows is negative? The asset is worth nothing.

Still, here are three alternative things you can do to deal with a negative DCF valuation:

#1) Modify the DCF Assumptions

You can modify the DCF model to use different discount rates for different cash flows, as they probably don’t have the same risk profile.

A debt repayment likely has lower risk than a discretionary capital expenditure, for example.

As a rule of thumb:

• Use the cost of debt as the discount rate for debt repayments.
• Use the cost of equity as the discount rate for capital expenditures funded by equity injections.
• Use the Weighted Average Cost of Capital (WACC) as the discount rate for operating cash flows.

You can also normalize earnings.

This is especially important for companies facing temporary problems in the year zero of your DCF model, as this will influence all the following forecasted years.

Simply adjust earnings so that they do not reflect the expenses associated with the temporary problem, be it a strike action, lawsuit, or product recall for example.

Make sure to also normalize earnings in case of an extraordinary good event, such as the sale of a building, to avoid overvaluing the company.

Overall, negative cash flow makes the process of valuation more complicated because you have to assume whether or not the firm will restructure itself to outlive its problems.

#2) Incorporate the Value of Real Options

What are real options?

Real options are the value of having the flexibility to adapt to changing market conditions and opportunities.

You can compute the expanded NPV by taking into account the flexibility to abandon, change, or expand a project.

This flexibility has value. But most times analysts ignore it and assume that once a project starts, you cannot stop or change it until it is over.

Real options are the value of managerial flexibility. And a lot of times, it will show you a project is actually profitable when the standard NPV says it is not.

#3) Use Other Valuation Methods

You don’t want to evaluate all companies based on free cash flow.

For instance, free cash flow is not a great tool for valuing a bank because its core business is managing deposits, originating loans, and providing financial services, making it difficult to separate operating cash flows from financing and investing activities.

Young startups are also difficult to value, as most don’t have a profit yet.

So, here are two alternatives to a DCF with negative cash flows:

• Relative valuation: This is when you compare a company’s valuation metrics (such as price ratios) to those of similar companies in the same industry. For instance, if you use the industry average revenue or EBITDA multiple to value the company you’re analyzing, you are assuming the firm’s margins will converge to industry averages soon.
• Dividend Discount Model (DDM): As we saw before, the value of an asset is the present value of all its future cash flows. For stocks, these cash flows are dividends. The DDM estimates the fair value of a company based on the present value of its future dividend payments. This is useful because most companies want to avoid decreasing their dividend payments, even when they have negative earnings.

In practice, analysts often use a combination of valuation methods to validate results and get a more comprehensive view of a company’s value.

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