FCFF vs FCFE

What is FCFF vs FCFE?

The difference between an organization's operating cash flow and its fixed asset and working capital expenditures is known as a Free Cash Flow to the Firm (FCFF).

It is part of a firm's cash flow that can be removed and handed to creditors and investors without negatively impacting operations.

Various approaches can be used to calculate free cash flow based on the target audience and the data. Depreciation and amortization are frequently included in earnings before interest and taxes (EBIT), and changes in working capital and capital expenditures are deducted.

Depending on the audience, other improvements and adjustments might also be made to lessen distortions. Free cash flow can differ from net income because it accounts for changes in working capital and the acquisition of capital goods.

Free Cash Flow to Equity (FCFE), also known as the flow to equity or the levered Free Cash Flow (FTE), describes the sum of money available after all expenses, reinvestments, and debt repayments before it can be distributed to the company's equity owners as dividends or stock buybacks.

The FCFE is the cash flow that shareholders can access, as opposed to dividends, which are the cash flows that are distributed to shareholders. Typically, the FCFE is determined as part of the DCF or LBO modeling and valuation.

The remaining cash flow is a free cash flow to the firm after the corporation pays all operational costs (including taxes) and expenditures necessary to support the firm's productive capacity.

Some of the sources of capital include the holders of: 

• Common Stock
• Bonds
• Preferred Stock
• Other claims

Free cash flow to equity is the term used to describe the cash flow only available to the company's common stockholders (FCFE). If equity, it's FCFF, and FCFE fully funds a company is the same.

Understanding Free Cash Flow to Firm (FCFF)

A company's profitability is determined by its FCFF, which accounts for all costs and reinvestments. It is one of the several benchmarks used to evaluate and compare the financial stability of a company.

Common methods of calculating the FCFF include: 

 FCFF = EBIT + D&A - Tax - NWC - CapEx

Where, 

• EBIT = Earnings Before Interest and Tax
• D&A = Depreciation, and Amortization
• NWC = Net Working Capital
• CapEx = Capital Expenditure

Or, 

FCFF = Net profit  + Interest - CapEx - Working capital  - Tax shield

Where, 

• CapEx= Net capital expenditure

Or,

FCFF= Profit before Tax - Capital expenditure + D&A - Working capital 

Or, 

Net FCF = Operation CF - CE - Dividends - Long-term debt - Depreciation

Where,

• Operation CF = Operating cash flow
• CE = Capital Expenses to keep the current level of operation.

We can also calculate the levered free cash flow by using the following formula: 

Levered free cash flow = Cash flow from operations - Investment in operating capital  

These formulas help us calculate and measure the free cash flow to the firm for the business. 

Free cash flow refers to a company's ability to pay dividends to shareholders, and the cash will be used to repay bondholders' principal and interest. Even successful companies are not immune from negative free cash flows.

Since free cash flow is harder to manipulate than net income, some investors prefer it to help gauge a company's financial performance and determine its intrinsic worth.

One interpretation of the DCF model is that a company's intrinsic value equals the present value of all anticipated future free cash flows. Discounting the free cash flows at the firm's weighted average cost of Capital (WACC) provides the present value in this scenario. 

While accounting for the purchase of capital goods, the free cash flow measure utilizes the net capital acquisitions from the prior period, and net income excludes Depreciation.

Understanding Free Cash Flow to Equity (FCFE)

The amount of cash a corporation generates that could be transferred to shareholders is called free cash flow to equity (FCFE). It is calculated by subtracting net debt issued from capital expenditures and adding cash from operations.

The basic formula used for calculating the FCFE: 

FCFE = Cash from Operating Activities – CapEx + Net Debt Issued (Repaid)

Where, 

• CapEx = Capital Expenditure

An alternative formula used is: 

FCFE = FCFF + Net borrowing - Interest (1 - t)

Where, 

• Interest (1 - t) = after-tax interest expense

The FCFE might be negative, just like FCFF. If FCFE is negative, the company will eventually—but perhaps not right away—need to raise or acquire fresh equity.

Some of the situations which lead to negative FCFE are when: 

1. The company has a negative net income.
2. Reinvestment requirements, such as a high CapEx, may outweigh net income. This is frequently the case for growth businesses, particularly in the early stages of the life cycle.
3. Large upcoming debt repayments must be financed with equity cash flows.
4. In the financial statement analysis, heavily leveraged companies attempt to reduce their debt ratios. 

If the FCFE is discounted, the projected return on equity should be used as the appropriate discount rate. This provides a simpler approach to figuring out equity value.

In simpler words, net income, investments, working Capital, and debt make up the FCFE.

Analysts frequently use the FCFE statistic to estimate a company's value. It has become a popular alternative to the dividend discount model (DDM) for valuation, particularly when a company doesn't pay dividends.

FCFF vs. FCFE

The major differences between the two cash flow terms, FCFF AND FCFE, are stated below:

These differences relatively explain the differences between the firm's free cash flow and the company's equity with its valuation, impact, and discount rate.

Using free cash flow to the company (FCFF) to calculate the enterprise value, equity instruments can be valued directly (equity valuation) or indirectly (subtract the fair value of the investee's debt net of tax from free cash flow to the firm).

Even though both methods produce discounted projected cash flows, the relevant cash flows and discount rates vary depending on which method is applied.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Equity Value
• EV/Capital Employed Ratio
• Types of Valuation Multiples
• Unlevered Beta / Asset Beta
• Unlevered Cost of Capital