Difference Between FCFF vs FCFE
FCFF is the cash flow available for discretionary distribution to all investors of a company, both equity and debt, after paying for cash operating expenses and capital expenditure. Since interest payments or leverage effects are not taken into consideration in the computation of FCFF, this measure is also referred to as an unlevered cash flow. FCFE is the discretionary cash flow available only to equity holders of a company. This is the residual cash flow left over after meeting all financial obligations and capital requirements. Thus interest payments or debt repayments are taken into consideration while computing FCFE.
Let us study much more about FCFF vs FCFE in detail:
Traditionally, while analyzing stocks, investors have focused on metrics like EBITDA, net income. While these metrics are significant for trading comps, a more accurate measure of company performance is the free cash flow (FCF) used in the discounted cash flow method (DCF). FCF varies from metrics like operating EBITDA, EBIT, or net income since the former leaves out non-cash expenses and subtracts the capital expenditure required for sustenance. FCF has also gained prominence against the dividend discount model of valuation, especially in the case of non-dividend paying firms.
What is FCFF?
Free cash flow refers to the cash available to investors after paying for operating and investing expenditures. The two types of free cash flow measures used in valuation are Free cash flow to the firm (FCFF) and Free cash flow to equity (FCFE).
Usually, when we talk about free cash flow we are referring to FCFF. FCFF is usually computed by adjusting operating EBIT for non-cash expenses and fixed and working capital investments.
FCFF= Operating EBIT- Taxes + Depreciation/Amortization (non-cash expenses)- fixed capital expenditure-Increase in net working capital
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Alternate methods of computation are:
FCFF= Cash flow from operations (from cash flow statement) + interest expense adjusted for tax – fixed capital expenditure
What is FCFE?
FCFF= Net Income + Interest expense adjusted for tax + Non-cash expense – fixed capital expenditure-Increase in net working capital
When we do DCF using FCFF, we arrive at enterprise value by discounting the cash flows with the weighted average cost of capital (WACC). Here the costs of all the sources of capital are captured in the discount rate since FCFF takes into consideration the entire capital structure of the company.
Since this cash flow includes the impact of leverage, it is also referred to as levered cash flow. Thus if the firm has common equity as the only source of capital, its FCFF and FCFE are equal.
FCFE is usually computed by adjusting post-tax operating EBIT for a non-cash expense, interest expense, capital investments, and net debt repayments.
FCFE=Operating EBIT- Interest- Taxes+ Depreciation/Amortization (non-cash cost)– fixed capital expenditure-Increase in networking capital-net debt repayment
Where net debt repayment= principal debt repayment –new debt issue
Alternate methods of computation are
FCFE= Cash flow from operations – fixed capital expenditure – Net debt repayments
When we do DCF using FCFF, we arrive at equity value by discounting the cash flows with the cost of equity. Here, only the cost of equity is considered as a discount rate since FCFE is the amount left over for only equity shareholders.
Had to Head Comparison FCFF vs FCFE (Infographics)
Below is the top 5 difference between FCFF and FCFE
Key differences between FCFF vs FCFE
Both FCFF vs FCFE are popular choices in the market; let us discuss some of the major differences:
- FCFF is the amount left over for all the investors of the firm, both bondholders and stockholders while FCFE is the residual amount left over for common equity holders of the firm
- FCFF excludes the impact of leverage since it does not take into consideration the financial obligations while arriving at the residual cash flow and hence is also referred to as unlevered cash flow. FCFE includes the impact of leverage by subtracting net financial obligations, hence it is referred to as levered cash flow
- FCFF is used in DCF valuation to calculate enterprise value or the total intrinsic value of the firm. FCFE is used in DCF valuation to compute equity value or the intrinsic value of a firm available to common equity shareholders
- While doing DCF valuation, FCFF is paired with a weighted average cost of capital to maintain consistency in incorporating all the capital suppliers for enterprise valuation. In contrast, FCFE is paired with the cost of equity to maintain consistency in incorporating the claim of only the common equity shareholders
FCFF vs FCFE Comparison Table
Below is the topmost comparisons between FCFF vs FCFE are as follows –
The Basic Comparison |
FCFF |
FCFE |
Meaning | Free cash flow available to all investors of a firm | Free cash flow available to common equity shareholders of a firm |
Impact of leverage | Excludes the impact of leverage, hence referred to as unlevered cash flow | Includes the impact of leverage as it subtracts interest payments and principal repayments to debt holders to arrive at the cash flow, hence referred to as levered cash flow |
Application | Used for calculating the enterprise value | Used for calculating the equity value |
The discount rate used while doing DCF valuation | The weighted average cost of capital is used to incorporate the cost of all capital sources in the entire capital structure | Cost of equity is used to maintain consistency with free cash flow available only to equity shareholders |
Varying perspective | Preferred by the management of highly leveraged companies as it provides a rosier picture of firm sustenance | Preferred by analysts as it provides a more accurate picture of firm sustenance |
Conclusion
In this FCFF vs FCFE article, we have seen that the FCFF is the free cash flow generated by the firm from its operations after taking care of all capital expenditure required for the firm’s sustenance with the cash flow being available to all providers of capital, both debt, and equity. This metric implicitly excludes any impact of the firm’s financial leverage since it does not consider financial obligations of interest and principal repayments for cash flow computation. Hence, it is also referred to as unleveled cash flow.
FCFE is the free cash flow available to only the common equity shareholders of a firm and includes the impact of financial leverage through subtraction of financial obligations from the cash flow. Hence, it is also referred to as levered cash flow. Thus, FCFE can also be computed by subtracting tax-adjusted interest expense and net debt repayments from FCFF.
Management of highly leveraged companies would prefer to use FCFF when presenting their operations. It needs to be checked that the company is not suffering from negative levered free cash flow on account of high financial obligations which could make the company unsustainable in the long term.
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