Intermediate Valuation: Free Cash Flow to Equity vs Free Cash Flow to Firm
When it comes to assessing companies, the best way is to conduct a detailed valuation using both qualitative and quantitative approaches. The income approach, a popular valuation method used by analysts, uses free cash flow as a base for calculating a value for the capitalization of earnings (“cap earnings”) and discounted cash flow (DCF) methods.
What Is Free Cash Flow?
Free cash flow is an earnings metric defined as the cash flow available after taxes, non-cash expenses, capital expenditures, and changes in operational working capital.
Free cash flow measures how much cash is available to shareholders after all required payments have been made. The terms “free cash flow to the firm (FCFF) and “free cash flow to equity” (FCFE) break down free cash flow further.
The Basics
The general principle of valuation using the income approach method is that a company’s value is the sum of its future cash flows, discounted or capitalized, to its present value. The valuation is not based on profit but free cash flow. As a shareholder, we are only interested in the actual cash flows.
However, many companies are financed not only through equity but also through debt. Lenders, such as banks or bondholders, are often involved in the financing of a company. Therefore, the type of FCF an analyst uses in their valuation changes based upon capital structure.
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The DCF
As already briefly mentioned, the DCF valuation method calculates value based upon the sum of the present value of project free cash flows. Richard Lawson, a former money manager of investment management company Weitz Funds, explained this concept:
I ask whether I would like to own a company at its current market price if I never had a chance to sell it to anybody else. From that perspective, all that matters is the long-term discounted free cash flow when you think about value. It is just a function of how much cash you should expect the company to pay out to its shareholders over its life, discounted back to the present.
– Richard Lawson in Wizards of Wall Street (1)
So, if we own a company, then that company’s value is derived from the excess cash the company generates year over year. The higher this excess cash (free cash flow), the high the value of the company.
FCFE and FCFF
Free cash flow to equity (FCFE) looks at the cash flow from the shareholder’s perspective; i.e., we only calculate the cash flow for the equity providers. In the valuation, we then directly determine the value of the equity.
Free cash flow to the firm (FCFF) takes the perspective of the entire company. As such, we calculate the cash flow for all forms of financing (shareholders and debt providers). We must subtract the net debt from the total indicated value in the valuation to arrive at the equity value.
Free Cash Flow to Equity (FCFE)
FCFE is used to determine the value of equity. It allows us to calculate how much “cash” a company can return to its shareholders. FCFE considers taxes, capital expenditure (CapEx), etc., as well as the repayment of loans or new borrowing.
To calculate the FCFE, we can choose different starting points. The most straightforward approach via net profit is also used in the published cash flow statements.
Starting from net profit, we can calculate the FCFE as follows:
FCFE = net profit + depreciation and amortization + changes in non-cash working capital + other non-cash components – CapEx + net borrowing
Components of the FCFE Formula
Net profit: Net profit is left after all expenses (including interest on borrowed capital) are paid. The net profit can be taken directly from the income statement.
Depreciation and amortization: Income statements often include depreciation and amortization. When depreciation and amortization are not clearly shown on the income statement, they will be outlined in the statement of cash flows or notes in the financial statements. With other non-cash expenses, we should weigh which ones we leave in net profit or add for the cash flow consideration.
Changes in non-cash working capital (WC): The change in WC can represent either an inflow or outflow of funds. Non-cash working capital includes inventories, trade receivables, and payables. We can also consider accrued liabilities. Changes in cash and current liabilities are not considered. When we start on the balance sheet, we should note that increased working capital has a negative cash impact.
CapEx: Property, plant, and equipment investments can be quickly taken from the cash flow statement. It is essential to anticipate the suitable investments required here, namely those necessary to maintain the current business or to enable planned sales and profit growth. For tech companies or knowledge-based companies, we should also consider investments in intangible assets.
Net borrowing: Analogous to working capital, this can either be a capital inflow or outflow. Therefore, we should only consider the net debts that have been added or repaid. If the debt increases, we first see a capital inflow. We should consider changes in short-term and long-term debts (interest-bearing debts are meant here; i.e., no trade payables that we have already considered in working capital).
When Can We Use FCFE?
Some companies (e.g., Coca-Cola) have stable debt-to-equity ratios over time: their capital structure is stable. For these companies, we can use FCFE. On the other hand, we should be careful with companies having strongly fluctuating debt levels. The FCFE would then only be strongly influenced by changes in the capital structure that have nothing to do with the operational business. In this case, we should use FCFF: look at the entire company value, including its debt.
Free Cash Flow to Firm (FCFF)
When a company’s capital structure is unstable, FCFF should be relied on rather than FCFE. FCFF is one of the most critical metrics for company valuation and represents the basis for calculating the company’s value using the discounted cash flow method. The most significant difference compared to FCFE is that FCFF considers both equity (shareholders) and debt providers.
Starting from net profit, we can calculate FCFF as follows:
FCFF = net profit + depreciation and amortization + interest x (1 – tax rate) + changes in non-cash working capital + other non-cash components – CapEx
Compared to calculating the free cash flow, there is only one difference: we add the interest–corrected for the tax advantage–back to the net profit and thus get the cash flow for all investors.
Different Components of the FCFF Formula
Interest x (1 – tax rate): Interest is a cash flow to a group of investors in a company. For this reason, the interest is also part of the FCFF. Because the interest for calculating the tax is deductible from the profit, we add the after-tax interest. We have two effects if we assume the net profit:
- We have a certain amount of interest, say $100, which we must add back to the net profit.
- At the same time, we have a lower tax burden due to the interest. At a tax rate of 30 percent, that would be $30.
Suppose we have no outside capital, for the time being, then we must correct both effects. Hence, we must add the $100 in interest back to the net profit and subtract the tax advantage that we have through this interest (namely the $30). So, we have an addition of $70 or expressed as a formula “Interest x (1 tax rate).”
Changes in non-cash working capital: The change in working capital can either be a cash inflow or outflow, depending on the year-over-year working capital change. The non-cash working capital includes inventories, receivables, and payables from trade. Changes in non-operating assets and liabilities are not included in the calculation of year-over-year change in working capital.
Other non-cash components: In addition to depreciation and amortization, we need to correct several other non-cash components in net profit for cash consideration. The cash flow statement gives us the best overview of these adjustments for a specific company.
CapEx: The investments in property, plant, and equipment (“CAPEX”) can be quickly taken from the cash flow statement (cash from investing activities). It is important to expect suitable investments here, especially those necessary to maintain current business or to enable planned sales and profit growth. This is where consistency is essential.
Incidentally, this is also a network analysis. So, if there are regular sales of property, plant, and equipment, we should consider these positively in the cash flow calculation.
Summary
FCFF takes a view of the entire company and shows the capital flows available to all investors. In calculating FCFF, the only difference from the FCF or FCFE is that we do not leave the capital flows to the lenders (interest) in the net profit but consider them as cash flows available to the lenders.
In the subsequent valuation using the discounted cash flow method, we first determine the value of the operative business based on the FCFF. We add non-operational components such as cash, investments, and results from other holdings. Finally, we subtract the entire debt and arrive at the intrinsic value of the equity.
