"A firm can arrive at a high ROC by using its capital to increase sales" — Aswath Damodaran
In his latest book on valuation, Aswath Damodaran pays less attention to the calculation of discount rates, and much more to the projection of cash flows. It's a bit less fun, but more useful. The key tool here is the sales-to-capital ratio; it allows us to compute reinvestment, a key input in FCFF estimations (*):
FCFF = EBIT (1 – t) – [Cap Ex – depreciation + ΔWC]
The second term to the right of the equation captures the reinvestment needed for growth: net investment (Cap Ex minus depreciation) plus additional net investments in working capital. The sales-to-capital ratio or capital turnover ratio is:
Sales-to-capital = sales / book value of debt and equity
The next step is to compute the change in sales and the change in capital, that is, reinvestment. Now all the pieces come together. If you have an estimation of the sales-to-capital ratio and a revenue (sales) projection, you can arrive at reinvestment by dividing the change in sales by the sales-to-capital ratio. For example, in the World Domination scenario for Amazon (p. 145) sales are projected at $246.9bn in year 6 and at $278.8bn in year 7, while the sales-to-capital ratio is kept constant at 3.68 times. Therefore reinvestment in year 7 is:
($278.8bn – $246.9bn) / 3.68 = $8.6bn
Now all that remains to do to arrive at FCFF is to subtract that number from the projection of the after-tax EBIT, which Prof. Damodaran puts at $17.3bn. Therefore, in year 7, Free Cash Flow to the Firm is $17.3bn – $8.6bn = $8.7bn.
(*) Aswath Damodaran. Narrative and Numbers. The Value of Stories in Business. New York: Columbia Business School, 2017. See also: "Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges", Stern School of Business, New York University, 2009, especially pp. 26-27
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