Free Cash Flow to the Firm and Equity

The discounted cash flow model is the most advocated model for valuing a stock. Under this model, an analyst will estimate the future cash flows for the company, and discount it with the appropriate discount rate.

Traditionally, analysts have used dividends as the proxy for cash flows, hence the dividend discount model. However, the problem with dividends is that it does not fully reflect the cash flow earned by the firm.

The two new cash flow measures used to value a firm are Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE).

FCFF represents the free cash flow available to both equity and debt holders, while FCFE represents free cash flow available for only equity holders.

A firm can be valued by estimating the Free Cash Flow to Firm and discounting them by the Weighted Average Cost of Capital (WACC). The value we arrive at will represent the value of the entire firm. We can then deduct the value of debt to arrive at the value of equity alone.

FCFF valuation is more suitable compared to FCFE when the company has high leverage, and/or negative FCFE. FCFF is also suitable for firms that have a tendency to frequently change their degree of financial leverage.

FCFF can be calculated from Net Income using the following formula:

FCFF from Net Income = Net Income + Non-cash Charges + (Interest Expense * (1-tax rate)) – Fixed Capital Investment – Working Capital Investment

One can easily extract the information required to value a firm using FCFF from the company’s financial statements.

FCFF can also be calculated using Cash Flow from Operations as follows:

FCFF from Cash Flow from Operations = Cash Flow from Operations – Fixed Capital Investment + Interest expense * (1 – tax)

FCFE is defined as the amount of free cash flow the firm has after meeting all its obligations. This includes debt obligations, capital expenditure to maintain existing assets, and new asset purchases to maintain the growth rate assumed. This is the cash that can be paid to shareholders after paying for all expenses, debt repayments, and reinvestments. Free Cash Flows to Equity are available to stock holders only; return of these cash flows to stock investors does not threaten the company’s existence as a going concern.

FCFE is calculated using the following formula:

FCFE = Net Income – (Capital Expenditure – Depreciation) – Change in Non-cash Working Capital + (New Debt Issued – Debt Repayments)

FCFE can also be calculated using Cash Flow from operations as follows:

FCFE from Cash Flow from Operations = Cash Flow from Operations – Fixed Capital Investment + Net Borrowing

Note that if we already have FCFF, we can use the value of FCFF to calculate FCFE as follows:

FCFE = FCFF – Interest expense * (1 – tax) + Increase in debt

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