FCFF vs FCFE: What's the Difference?

Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) are two key metrics that analysts, investors, and financial professionals rely on to evaluate a company's cash flow and financial health. Understanding the distinction between FCFF vs FCFE is crucial when determining which cash flow measure is more appropriate for valuing a company or assessing its financial stability.

Both FCFF and FCFE help measure the amount of cash available to a company's shareholders, but the way each metric is calculated and interpreted is different. This article breaks down the differences between FCFF and FCFE, their formulas, and how to use them in financial analysis.

Understanding FCFF vs FCFE

The primary difference between FCFF and FCFE lies in the types of capital providers they account for:

FCFF (Free Cash Flow to the Firm) measures the total cash flow available to all capital providers, including debt holders and equity holders. It represents the cash flow generated by the company's operations that can be used to repay debt, reinvest in the business, or distribute to shareholders.

FCFE (Free Cash Flow to Equity) measures the cash flow available specifically to equity holders, i.e., shareholders. It excludes debt payments and focuses solely on the cash available to owners of the company after debt obligations have been met.

How to Calculate FCFF and FCFE

One of the most common ways to derive FCFF is by adding tax adjusted interest expense (TAIE = Interest Expense * (1 - Tax Rate) to the companies operating cash flow (OCF), then subtracting capital expenditures (capex). The formula would look something like this:

FCFF = OCF + Tax-Adjusted Interest Expense (TAIE) - Capex

FCFE is calculated by subtracting capex from operating cash flows, and then adding back debt issuance.

FCFE = OCF - Capex + Net Debt Issuance

Why are FCFF and FCFE important?

FCFF and FCFE are important metrics for investors because they measure a company's ability to generate cash flow that can be used to pay dividends, invest in new growth opportunities, or repay debt.

FCFF is particularly important for creditors, as it is a measure of how much cash a company has available to service its debt obligations. FCFE is important for equity investors, as it is a measure of how much cash a company has available to return to its shareholders in the form of dividends or share buybacks.

How to Use FCFF and FCFE in Financial Analysis

FCFF and FCFE can be used in a number of ways, including:

• Company Valuation:
  • FCFF vs FCFE plays a significant role in company valuation using the discounted cash flow (DCF) model. FCFF is typically used when valuing the entire company (enterprise value), while FCFE is used for equity valuation.
  • To streamline the valuation process, you can leverage tools like FMP's Discounted Cashflow Reports API, which provides detailed DCF calculations based on FCFF and FCFE. This allows analysts to automate and access accurate DCF valuations quickly, ensuring comprehensive financial analysis.
• Credit Analysis:
  • FCFF is often utilized in credit analysis to evaluate a company's ability to meet its debt obligations and overall financial stability.
• Dividend Sustainability:
  • FCFE can be used to assess a company's ability to sustain dividends, ensuring that enough free cash flow is available to continue paying shareholders.
• Investment Comparison:
  • Analysts may compare FCFF and FCFE across companies in the same industry to identify investment opportunities and assess which company is more efficient in generating free cash flow for its stakeholders.

When to Use FCFF vs FCFE

FCFF is typically used to value companies, while FCFE is used to value equity. FCFF is also used to evaluate a company's ability to service its debt.

Example:

Let's say that a company has the following financial statements:

To calculate FCFF we first must find the effective tax rate for the company, to do this we can use the income before tax and the Income Tax paid fields as such:

Tax Rate = Income Tax Expense / Income Before Tax

Tax Rate = 3M / 13M = 23.077% = ~23.08%

Next, we can locate OCF to be $8M, Interest Expense to be $7M, and Capex to be $1M (in addition to our tax rate above of 23.08%). Now we have the necessary innputs to calculate FCFF, which can be done like so:

FCFF = OCF + Tax-Adjusted Interest Expense (TAIE) - Capex

FCFF = $8M + (-$7M * (1 - 0.2308)) - $1M

FCFF = $8M - $5.385M - $1M

FCFF = $1.615M

Lastly, we can use these same inputs alongside Net Debt Issuance (from the cashflow statement) to caluclate FCFE:

FCFE = OCF - Capex + Net Debt Issuance

FCFE = $8M - $1M + $1.5M

FCFE = $8.5M

Conclusion

FCFF and FCFE are two important metrics that can be used to value companies and evaluate their financial performance. FCFF is typically used to value companies, while FCFE is used to value equity. FCFF is also used to evaluate a company's ability to service its debt.