Comparing FCFF and FCFE: Which One Should You Use?

 

Free cash flow metrics are essential tools for investors to understand how much cash a company generates and how much is available for distribution. Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) are two primary types, each serving a unique purpose in company valuation. While FCFF represents the cash flow available to both debt and equity holders, FCFE specifically calculates the cash left after covering all debt obligations, focusing only on equity holders.

In this blog, we’ll explore the key differences between FCFF and FCFE, how they’re calculated, and when to use each one. Plus, we’ll look at real-life examples to see these concepts in action.

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What is FCFF?

Free Cash Flow to the Firm (FCFF) is the cash flow generated by a company’s core operations, representing the amount available to all stakeholders—both debt and equity holders—before any interest or debt payments. This metric gives a full picture of the cash flow a company produces, independent of its financing structure.

Formula for FCFF:

$$\text{FCFF}=\text{EBIT}\times (1-\text{Tax Rate})+\text{Depreciation}-\text{Capital Expenditures}-\mathrm{\Delta }\text{Working Capital}$$

This metric is particularly valuable because it’s neutral to how a company is financed (debt vs. equity), making it useful for valuing the entire firm.

Example: Google (Alphabet Inc.) and FCFF

Alphabet, Google’s parent company, consistently generates high FCFF, primarily due to its advertising business and its high operating efficiency. Alphabet uses its FCFF to invest in long-term projects, such as artificial intelligence, Google Cloud, and self-driving cars (Waymo), which strengthen its market position and diversify its revenue streams.

In 2022, Alphabet reported $91 billion in free cash flow, much of which supported investments in new technologies and acquisitions. FCFF helped Alphabet plan its long-term growth strategy, as this measure reflects the firm’s cash flow regardless of its debt levels.

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What is FCFE?

Free Cash Flow to Equity (FCFE), on the other hand, measures the cash flow specifically available to equity shareholders after accounting for all debt payments (interest and principal). This metric is useful for equity investors, as it reflects the actual cash that could theoretically be distributed to shareholders.

Formula for FCFE:

FCFE=Net Income+Depreciation/Amortization−Change in Working Capital−Capital Expenditures+Net Borrowings

Since FCFE takes debt payments into account, it’s affected by the company’s leverage. Therefore, companies with high and fluctuating debt may show volatile FCFE figures.

Example: McDonald’s and FCFE

McDonald’s has used FCFE to boost its shareholder returns. The fast-food giant regularly issues debt to finance share buybacks and dividends, resulting in a high FCFE, which allows it to return significant capital to shareholders. In 2020, McDonald’s reported strong FCFE despite challenges in the restaurant industry, enabling the company to continue paying dividends and buying back shares.

This approach, however, requires careful debt management, as the company must ensure its debt levels remain sustainable to keep generating high FCFE.

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Key Differences Between FCFF and FCFE

1. Debt Treatment:

   • FCFF is calculated before debt payments, making it a measure available to all capital providers.
   • FCFE takes debt payments into account, showing the cash specifically left for equity holders.

2. Stakeholder Focus:

   • FCFF is useful for valuing the entire firm, as it shows cash flow available to both debt and equity holders.
   • FCFE focuses solely on equity holders, making it ideal for understanding the cash available for dividends or stock buybacks.

3. Impact of Leverage (Debt):

   • FCFF remains unaffected by changes in the company’s debt structure, providing a steady picture of operating performance.
   • FCFE is more sensitive to leverage, as debt payments directly impact the cash available for equity holders.

4. Application in Valuation:

   • FCFF is used in Discounted Cash Flow (DCF) models to value the entire firm and is commonly discounted at the Weighted Average Cost of Capital (WACC).
   • FCFE is used to value only the equity portion of the firm and is discounted at the Cost of Equity.

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When to Use FCFF vs. FCFE

Use FCFF When:

1. The Company Has High or Fluctuating Debt Levels:

   • Since FCFF does not account for debt payments, it provides a stable measure of cash flow, regardless of the company’s capital structure. For instance, companies with high or variable debt loads, like Ford and General Electric, use FCFF to monitor cash flow before debt obligations.

2. You’re Valuing the Entire Firm:

   • FCFF is ideal for valuing the entire firm, especially for prospective acquisitions or mergers, where the goal is to understand the total value available to all stakeholders.

3. Capital Structure is Expected to Change:

   • When a company’s debt structure is likely to shift (e.g., through a leveraged buyout or refinancing), FCFF remains consistent, making it a preferred metric for such scenarios.

Use FCFE When:

1. The Company’s Debt Level is Stable or Manageable:

   • FCFE works best for companies with low or stable debt levels, where debt repayments do not significantly affect cash flow, making it a more accurate measure of shareholder value.

2. You’re Valuing Equity Only:

   • FCFE is more appropriate for equity investors, as it shows the cash available specifically for shareholders after covering debt obligations.

3. The Goal is to Assess Dividend or Buyback Capacity:

   • Companies like Apple and Microsoft use FCFE to determine how much cash they can return to shareholders. These companies have substantial FCFE, allowing them to provide consistent dividends and repurchase shares.

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Real-Life Comparison: Tesla and Coca-Cola

Tesla and Coca-Cola are two companies where the use of FCFF versus FCFE provides unique insights:

• Tesla: As a high-growth company with considerable capital expenditures and fluctuating debt levels, Tesla often uses FCFF for valuation. Tesla’s large investments in Gigafactories and R&D create high operating expenses, so FCFF provides a clear view of its potential cash generation before considering debt payments. In recent years, Tesla has started generating positive FCFF, which contributed to its rising stock price. Investors value Tesla based on its FCFF growth, as this reflects its ability to fund expansion without needing external financing.        
• Coca-Cola: Coca-Cola, a stable and mature company, generates steady cash flows with manageable debt levels, making FCFE a suitable measure. Coca-Cola’s consistent FCFE allows it to pay regular dividends to shareholders, which is a significant aspect of its investment appeal. In 2021, Coca-Cola reported strong FCFE, enabling it to maintain its dividend payments despite economic uncertainty. This makes FCFE ideal for Coca-Cola, as it shows the cash flow available to reward shareholders, supporting the company’s reputation as a dividend stalwart.

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Pros and Cons of FCFF and FCFE

Aspect	FCFF	FCFE
Focus	Cash flow available to both debt and equity holders	Cash flow available only to equity holders
Debt Sensitivity	Not sensitive to debt payments	Sensitive to changes in debt, as it accounts for repayments
Valuation Use	Used for valuing the entire firm	Used for valuing only the equity portion
Preferred For	High-debt firms or firms with changing capital structures	Firms with stable debt, focused on dividends or buybacks
Stakeholder View	Useful for understanding the company’s total cash generation	Useful for assessing equity holder value

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Key Takeaways and Decision Guide:

When choosing between FCFF and FCFE, consider the company’s capital structure, purpose of valuation, and financial stability:

• Use FCFF for companies with high debt levels or when valuing the entire company, especially if there’s a possibility of capital structure changes.
• Use FCFE for firms with stable debt levels or when you’re focused on understanding cash available for equity holders.

Both metrics are valuable, but they serve distinct purposes depending on the company's debt and growth strategy.

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Conclusion: The Power of FCFF and FCFE in Valuation

Understanding the difference between FCFF and FCFE is essential for making informed investment decisions. FCFF provides a complete picture of a company’s cash generation, ideal for valuing the entire business, while FCFE focuses on the cash flow available to equity shareholders, making it perfect for dividend analysis or buyback capacity.

By knowing when to use FCFF versus FCFE, investors can better assess a company’s ability to create value for its stakeholders. Whether it’s Alphabet investing in growth with its high FCFF or Coca-Cola using its stable FCFE to reward shareholders, these cash flow metrics reveal valuable insights into a company’s financial health and strategic potential.

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Key Takeaways:

• FCFF shows cash available to both debt and equity holders, ideal for firm-wide valuation.
• FCFE reveals cash left for equity holders after debt payments, best for understanding shareholder value.
• Real-world examples like Tesla’s growth focus and Coca-Cola’s dividend stability illustrate the practical use of these metrics.