How to Calculate FCFF and FCFE: A Practical Guide

 

How to Calculate FCFF and FCFE: A Practical Guide

Introduction to Free Cash Flows

Free Cash Flow is an essential measure for anyone analysing a company’s finances. Among the different types, FCFF and FCFE are widely accepted in deciding a company’s financial health, the potential to gain from investments and its value. Being able to work out FCFF and FCFE is vital for those analysing a business who don’t rely only on net income or EBITDA.

Understanding FCFF (Free Cash Flow to the Firm)

Free Cash Flow to the Firm (FCFF) is the amount of cash the company earns from operations that goes to both debt and equity investors. It shows the cash amount a firm can give to all its investors while still running its operations. In this case, FCFE is the money left out of cash flow once all repeat expenses, additional investments and debt obligations are covered and it belongs solely to the company’s equity shareholders. Both approaches use the firm’s operations as their base, but they have different ways of including capital structure considerations.

The calculation of FCFF depends on first understanding the income statement and cash flow statement. The most popular technique begins with NOPAT which equals Operating Income or EBIT times one minus the tax rate. NOPAT means the earnings from a company’s main activities, once the impact of taxes is taken away but the effects of capital are not included. Therefore, it offers a straightforward picture of how work is being done. After determining NOPAT, it is necessary to add back depreciation and amortization expenses, since they do not come out of your wallet.

After that, adjustments are made for changes in working capital. A company that finds its working capital increasing needs to utilize more funds for operations, so less money is available for stakeholders. At the same time, a lower amount of working capital can produce additional cash. Once the impact of working capital is taken care of, the Capex amount must be subtracted. Capex involves the use of funds to buy or build fixed assets that keep or boost the company’s daily operations. In the end, the FCFF formula looks like this: FCFF = NOPAT + Depreciation and Amortization – Changes in Working Capital – Capital Expenditures. The figure includes all the firm’s earnings, after repairing or updating its key facilities and before giving out interest or payouts through dividends.

Understanding FCFE (Free Cash Flow to Equity)

Because FCFE covers only equity holders, there are extra factors to take into account when doing the calculations. First, we look at Net Income which already calculates interest expenses and taxes. To understand the actual cash flow, we include depreciation and amortization into net income. After that, we adjust both for changes in working capital and for investments in capital expenditures, similar to what we did with FCFF. Even so, since FCFE disregards debt, we need to add down any net borrowing to the cash provided from operations. New borrowings less debt repayments form this concept. Therefore, the formula for FCFE is expressed as: FCFE = Net Income + Depreciation and Amortization – Changes in Working Capital – Capital Expenditures + Net Borrowing.

 

Key Differences Between FCFF and FCFE

When it comes to valuing a company, FCFF is different from FCFE. In the Discounted Cash Flow (DCF) method, the worth of a company is found by reducing its FCFF value to present value using the company’s WACC. WACC measures the amount of return all the firm’s investors, debt and equity, would need on average. Since both FCFF and WACC reflect cash flows for all capital providers, using WACC keeps the results accurate. Unlike FCFF, FCFE is discounted using equity costs, as this amount is provided to investors as dividends only. The end point of FCFE calculation is the value of the company’s equity, but FCFF-based valuation calculates the value of the entire company. It is important to subtract net debt from the enterprise value to find out the equity value.

Calculations of FCFF and FCFE depend on making sure numbers and interpretation of financial statements are correct. For this reason, the matching of depreciation and amortization should come from the cash flow statement, since only it measures cash transactions. Just as with operating activities, capital expenditures may be drawn from the investing section of the cash flow statement. Experts must stay alert when calculating how working capital is moving. Because we are interested in the operating structure, we need to omit cash and interest-bearing liabilities from our list of working capital components. Among the usual working capital items are accounts receivable, inventory and accounts payable.

Real-World Complexities in Calculation

In many cases, real-world events and conditions make calculating FCFF and FCFE more complicated. When capital expenditures are not regular, the company’s free cash flow can change a lot, making it harder to predict upcoming cash flows. When firms are fast-growing or reorganizing, the shifting size of working capital may cause cash flow trends to seem different from what is really happening. If firms regularly borrow or repay money, the results for FCFE will be more variable due to the net borrowing contribution.

Why Analysts Prefer FCFF and FCFE Over Net Income

Even with these problems, FCFF and FCFE play important roles in equity research, investment banking and corporate finance. They reveal a clearer measure of the company’s cash-generating performance than net income which may be impacted by unusual or accounting-based factors. Additionally, because cash flows are less easy to manipulate than earnings, free cash flow analysis can compare companies from different industries much more effectively.

A further issue to consider is projecting FCFF and FCFE for use in valuation models. Usually, analysts use known facts about things like revenue growth, earnings and planned spending to estimate future numbers. After that, the projections are adjusted to the present time using the WACC or cost of equity rate. It is common to make assumptions in terminal value estimation using a perpetuity growth model, assuming steady growth forever. The reliability of these models depends on having strong FCFF or FCFE estimates which is why it’s essential to know the factors involved in creating them.

Conclusion

Being able to figure out and understand FCFF and FCFE helps analysts and investors make better decisions. The metrics covered here offer important information about how able the company is to create value for its shareholders, both through investments and in other ways. Just like other financial measures, you should use free cash flow along with other ratios and information to get a true picture of how the company is doing.