What are FCFF and FCFE approaches to valuation?

Ruchi Gandhi

24 Jan, 2022

Two terms FCFF and FCFE sound quite similar and may be easily confused. Free Cash Flow to Firm (FCFF) (also known as Unlevered Free Cash Flow) and Free Cash Flow to Equity (FCFE), which is also known as Levered Free Cash Flow, are the two forms of free cash flows. The discount rate and numerator of valuation multiples vary depending on the kind of cash flow employed, therefore knowing the difference between FCFF and FCFE is critical.

What is Free Cash Flow?

Before delving into the differences between FCFF and FCFE, it is crucial to first comprehend what Free Cash Flow (FCF) is. After accounting for non-cash expenses, changes in operating assets and liabilities, and capital expenditures, free cash flow is the quantum of cash flow generated (net of taxes) by a company. Simply put, free cash flow refers to the funds that remain after all payments, investments, and other obligations have been met. The monies left over for distribution among stockholders, bondholders, and investors are referred to as free cash flow.

Because they exclude substantial capital expenditures and changes in cash owing to changes in operating assets and liabilities, Free Cash Flow is a more accurate indicator than EBITDA, EBIT, and Net Income. Non-cash expenses are also included in measurements like EBIT and Net Income, which further distorts the view of the underlying cash flow of a company.

An overview of FCFF and FCFE

After paying off cash operating expenses and capital expenditures, FCFF is the cash flow available for optional pay-out to all investors in a corporation, both equity and debt. FCFF is also referred to as an unleveraged cash flow because interest payments and leverage effects are not taken into account when calculating it.

FCFE, on the other hand, is a type of discretionary cash flow that is solely available to a company’s stockholders. After all financial obligations and capital requirements have been met, this is the remaining cash flow. In order to calculate FCFE, interest payments or loan repayments are taken into account.

Investors have traditionally focused on indicators such as EBITDA and net income when appraising equities. While these measures are important for trading comparisons, the free cash flow (FCF) employed in the discounted cash flow approach (DCF) is a more accurate assessment of corporate profitability. FCF differs from operating EBITDA, EBIT, and net income in that it excludes non-cash expenses and subtracts the capital investment required to maintain the business. FCF has also gained traction as a viable alternative to the dividend discount model of valuation, particularly for non-dividend generating companies.

Meaning of FCFF

After operational and investing expenses are paid, free cash flow is the amount of money available to investors. Free cash flow to the firm (i.e., FCFF) and Free cash flow to equity (i.e., FCFE) are two different forms of free cash flow measurements used in valuation. We usually refer to FCFF when we speak of free cash flow (FCF). Operating EBIT is normally adjusted for non-cash expenses as well as fixed and working capital investments to arrive at FCFF.

FCFF = Operating EBIT – Tax + Depreciation or Amortization (non-cash expenses) – Fixed capital expenditures – Increase in net working capital

Alternatively, FCFF = Cash flow from operations (taken from cash flow statement) + Interest expense adjusted for tax – Fixed capital expenditures

FCFF = Net Income + Interest expense adjusted for tax + non-cash expenses – Fixed capital expenditures – Increase in net working capital

Thus, FCFF stands for free cash flow for the firm and it is a financial performance metric that looks at the amount of cash created by a company after all expenses, taxes, changes in net working capital, and changes in investments have been taken into account.

After all other outflows have been controlled and paid, the FCFF is the amount that is dispersed to the firm’s stockholders and bondholders. Calculating the FCFF is necessary for any business because it serves as a tool for measuring its profitability and financial stability. If the FCFF has a positive value, it means the company has a surplus after expenses are stripped away; if the FCFF has a negative value, the company is in danger of not having enough revenue to cover expenses or investments^[1].

Meaning of FCFE

FCFE is a term that stands for free cash flow to equity and it indicates the amount that is distributed to equity shareholders once all expenses, changes in net working capital, debt repayments, etc. are decreased and new loans are added.

The calculation of FCFE is important since it will aid in determining the firm’s value. FCFE is often used by experts to assess the value of a firm or company, and it can be used in place of dividends for this objective. When FCFE is used in stock valuation, this is demonstrated. Instead of dividends, as in the dividends discount model, the FCFE model of stock valuation uses free cash flow to equity to value stock.

We arrive at enterprise value whenever we apply DCF using FCFF by discounting the cash flows with the weighted average cost of capital (i.e., WACC). Because FCFF considers the complete capital structure of the company, the costs of all sources of capital are included in the discount rate.

This cash flow, i.e., FCFE is also known as levered cash flow because it includes the impact of leverage. As a result, if the firm’s primary source of capital is common equity, its FCFF and FCFE are likely to be equal.

But when we use the FCFE model to construct a DCF, we discount the cash flows with the cost of equity to arrive at an equity value. Because FCFE is the amount left over for only equity shareholders, only the cost of equity is treated as a discount rate.

Normally, FCFE is calculated after adjusting the post-tax operating EBIT of a company in respect of non-cash costs, interest expenses, capital investments, & net debt repayments.

FCFE = Operating EBIT – Interest – Tax + Depreciation or Amortization (non-cash expenses) – Fixed capital expenditures – Increase in networking capital – Net debt repayment

Alternatively, FCFE = Cash flow from operations – Fixed capital expenditures – Net debt repayments + New debt

Important points related to FCFF and FCFE

In the marketplace, both FCFF and FCFE are popular options. Following are some of the important points related to them:

• FCFF indicates the value remaining out for all of the firm’s investors, including bondholders and shareholders, whereas FCFE denotes the amount left over for the firm’s common equity holders only.
• FCFF ignores the effect of leverage because it does not include the financial obligations when calculating residual cash flow, and is hence also referred to as unleveraged cash flow. On the contrary, FCFE is referred to as levered cash flow since it considers the impact of leverage by removing the net financial liabilities.
• In the DCF valuation, FCFF is used to compute enterprise value or the firm’s entire intrinsic value. Similarly, in the DCF valuation, the FCFE model is used to calculate the equity value or the intrinsic value of a company that is available to common equity shareholders.
• To maintain consistency in considering all capital sources for enterprise valuation, FCFF is combined with a weighted average cost of capital while doing DCF valuation. FCFE, on the other hand, is used in conjunction with the cost of equity to ensure that only common equity shareholders’ claims are taken into account.
• When presenting their activities, management of highly leveraged organizations likes to employ FCFF. It is necessary to verify that the company does not have a negative levered free cash flow as a result of large financial obligations, as this could make the organization unsustainable in the long run.

Conclusion

FCFF is the firm’s free cash flow generated from operations after all capital expenditures essential for the firm’s survival have been paid out, and the cash flow is available to all capital providers, including debt and equity. Because it does not account for financial obligations of interest and principal repayments at the time of computation of cash flow, this indicator implicitly eliminates the impact of the firm’s financial leverage. As a result, unleveraged cash flow is also a term used to describe it.

FCFE is the free cash flow available only to common equity shareholders of a company, and it takes into account the impact of financial leverage by deducting all the financial liabilities from the cash flow. As a reason, it is also known as leveraged cash flow. By deducting tax-adjusted interest expenditure and net debt repayments from FCFF, FCFE may be easily calculated.

Read our Article: Cash Flow Forecasting in Financial Model