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