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101 Concepts for the Level I Exam

Essential Concept 51: FCFF and FCFE Approaches to Valuation


Free cash flow to the firm (FCFF) is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. A firm’s suppliers of capital include common stockholders, bondholders, and preferred stockholders.

Free cash flow to equity (FCFE) is the cash flow available to the company’s common stockholders after all operating expenses, interest, and principal payments have been paid and necessary investments in working and fixed capital have been made.

The two methods to value equity using free cash flows are:

  • Discount FCFF at the weighted average cost of capital (WACC) because FCFF is an after-tax cash flow. Then, estimate the value of equity by subtracting the value of debt from the estimated value of the firm.
  • Discount FCFE at the required return of equity.

FCFF is preferred over FCFE for

  • a levered company with negative FCFE, or
  • for a company with changing capital structure.

In free cash valuation, the focus is on the value of assets needed to generate operating cash flows. Analysts often exclude non-operating assets such as cash and marketable securities. However, if the non-operating assets are significant and were excluded, then they must be added to the value of operating assets.

Value of firm = Value of operating assets + Values of non-operating assets