2 Variations of Free Cash Flow: FCFF And FCFE

0
2 Variations of Free Cash Flow: FCFF And FCFE
Free Cash Flow

Cash flow analysis is an important tool that every investor should have in their toolbox. The most common and a relatively straight forward cash flow metric is the free cash flow yield which we have covered in an earlier post. Today, we will go deeper and distinguish between the different forms of free cash flow, namely free cash flow to firm (FCFF) and free cash flow to equity (FCFE).

Free cash flow to firm

FCFF represents the amount of cash flow that is available for distribution among all security holders. Security holders include debt, preferred stock holders and common stock holders. In other words, it is the cash flow that is available to the entire firm (which comprises of all the different providers of capital), hence the name; free cash flow to firm. The calculation of FCFF is one which more of us are familiar with:

ValueWalk’s January 2021 Hedge Fund Update Now Out!

valuewalk Q4 2020 hedge fund letters to investorsValueWalk's Hedge Fund Update newsletter for the month of January 2021. Please fund a full PDF for your use below. The PDF can be viewed online, downloaded or printed out. Renaissance’s Medallion Fund Surged 76% in 2020 SORRY! This content is exclusively for paying members. SIGN UP HERE If you are subscribed and having an Read More


Free cash flow to firm = Cash from Operating Activities – Capital Expenditures

Implications

Does the FCFF represent the amount of cash I, as an equity investor, will receive? No. As we have mentioned, this is the cash flow to the entire firm. Preferred stock holders and debt holders have a higher priority over equity holders in terms of receiving payments. The FCFF does not account for these principal and interest payments. Consequently, if you discount the FCFF to a present value, it will give you the value of the entire firm and you need to subtract the total amount of liabilities before you can obtain the value of equity which is your intrinsic value.

Free cash flow to equity

As you can probably infer from the name itself, FCFE sidesteps the issue with FCFF by stripping out all payments accruing to non-equity holders. It therefore represents the amount of cash flow an equity holder directly receives by investing in a firm. The official formula for FCFE is as follows:

Free cash flow to equity = Free cash flow to firm – Interest Payments + Debt Raised – Debt Repaid

Implications

Because FCFE is a direct measure of cash flow to equity holders, discounting the FCFE to a present value will immediately yield the intrinsic value of equity. There is no need to subtract liabilities. Lastly, note that the official formula for FCFE includes debt raised. I am not sure if I am comfortable with that. A company can artificially increase its FCFE by simply borrowing increasing amounts of money. This is theoretically correct – the amount of money raised through debt can be used to benefit equity holders (either through dividends or share buybacks). Nevertheless, this debt will have to be repaid sometime in the future and it seems almost delusional to regard raising debt as a sustainable source of cash flow for equity holders. We leave it to your judgement as to how you want to adjust for it.

Final words

It is important to distinguish between the 2 different types of free cash flow – an investor who bases his decision on FCFF yield runs the risk of developing overly-optimistic expectations. This distinction is less important when companies have low levels of debt, highlighting one of the benefits of low debt companies – higher free cash flow to equity holders.

The post 2 Variations of Free Cash Flow appeared first on ValueEdge.

Free Cash Flow

Previous article BlackBerry Ltd May Not Hit FY16 Projections: Analysts
Next article Trading Group Plus500 Snapped Up By PlayTech
I developed my passion for investment management especially equity research at a relatively young age. My investment journey began when I was 20, at a point in time where markets were still recovering from the Global Financial Crisis. My portfolio started from money I saved over the past years and through working during the holidays. I was fortunate to have a good friend with common investing mentality to began my journey towards value investing. To date, we still research and invest in companies together, discussing valuations and potential risks of a company. To date, I manage a fund with a value investing style. Positions are decided upon via a bottom-up approach or smart speculation (a term I came up with when buying a stock for quick profit due to a mismatch in prices in the market due to takeovers/selling of a subsidiary or associate). Apart from managing my own portfolio, I enjoy sharing my research with family and friends, seeking their opinions and views towards the stock. Reading Economics in London, I constantly keep up with the financial news in Singapore & Hong Kong. Despite my busy schedule, it has not stopped me from enjoying other aspects of life. I enjoy a variety of activities in whatever free time I may have – endurance running, marathons, traveling, fine dining, whiskey appreciation, fashion. Lastly, I enjoy meeting new people, discussing ideas and gaining new perspectives towards issues in the world.

No posts to display