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.

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