Free Cash Flow Valuation

FCFF vs. FCFE Definitions

FCFF: Free Cash Flows to the Firm are available to both suppliers of equity and debt capital; return of these cash flows to stock and bond investors does not threaten the company’s existence as a going concern.

WACC & FCFF: When performing a company valuation using discounted FCFFs, the discount rate applied should be the weighted average cost of capital (based on the target capital structure), to reflect both the cost of equity and cost of debt.

Value0 = Σ  FCFFt / (1+WACC)t

Equity Value = Calculated Firm Value – Market Value of Debt

This can be converted to a share price by dividing the Equity Value by the number of shares outstanding.

FCFE: 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.

Value0 = Σ  FCFEt / (1 + rce)t

The equity value derived from an FCFE analysis can then be divided by the number of shares outstanding to arrive at a share price.

Selecting FCFF or FCFE

The following situations can help an analyst decide which valuation approach is more appropriate:

• If the company has a consistent capital structure, then FCFE can be used in the valuation.
• If the company is highly leveraged and negative Free Cash Flows to Equity, then FCFF may be more appropriate.
• FCFF can be more appropriate when valuing a company that regularly changes its degree of financial leverage.

FCF Modeling vs. Dividend Discount Modeling (DDM)

Advantages and/or Appropriateness of FCF Valuation over DDM Valuation:

• FCF approaches can be applied companies that do not pay dividends.
• FCF approaches may be better for companies currently paying an unsustainable dividend.
• The FCFE model can be used when performing a valuation from a control perspective, as the majority owner will have discretion over how to use the equity cash flows; in contrast, DDM modeling may better reflect the view of a small shareholder who does not have control.

Calculating FCFF and FCFE

FCFF from Net Income