Discounted cash flow valuation - FCFF and FCFE models

Learning Outcomes

After reading this article, you will be able to distinguish between free cash flow to the firm (FCFF) and free cash flow to equity (FCFE), explain when to use each method, calculate FCFF and FCFE from financial statements, and apply discounted cash flow valuation models to derive firm and equity values. You will also learn to recognize the key assumptions, strengths, and limitations of these models for the CFA Level 2 exam.

CFA Level 2 Syllabus

For CFA Level 2, you are required to understand how discounted cash flow models are applied to equity valuation, with specific focus on free cash flow approaches. As part of your revision for this topic, ensure you can:

• Distinguish between FCFF and FCFE, and select the appropriate model for a given company or scenario
• Explain and perform the adjustments required to calculate FCFF and FCFE from net income, EBIT, EBITDA, or CFO
• Calculate firm and equity valuation using single-stage and multistage DCF models
• Explain the effects of capital structure, dividends, share repurchases, and changes in financial gearing on FCFF and FCFE
• Use sensitivity analysis to assess valuation outcomes
• Compare the strengths and limitations of DCF methods for valuation

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which formula best represents free cash flow to equity (FCFE) when starting from net income?
2. What distinguishes the ownership viewpoint implied by the FCFE approach from that of the dividend discount model?
3. Which of the following is typically discounted at the weighted average cost of capital (WACC) when calculating firm value?
4. In a stable growth company with volatile capital structure, which cash flow model is generally preferred for valuation?

Introduction

Discounted cash flow (DCF) models are core to equity valuation in the CFA curriculum. Instead of focusing on dividends, these models use measures of free cash flow—either to the firm (FCFF) or to equity holders (FCFE)—as the basis for valuation. FCFF and FCFE approaches are widely used because they can be applied even when dividend policies are irregular or capital structures are changing. This article will cover the purpose, calculation, and application of FCFF and FCFE models, along with their strengths, limitations, and common exam pitfalls.

Key Term: free cash flow to the firm (FCFF)
The cash flow available to all providers of capital (debt and equity) after operating expenses, taxes, and necessary investments in fixed and working capital.

Key Term: free cash flow to equity (FCFE)
The cash available to common shareholders after funding operating expenses, investments, interest, and debt repayments.

FCFF AND FCFE MODELS: PURPOSE AND SELECTION

DCF valuation models estimate either the total value of a firm (using FCFF) or the value of equity (using FCFE).

• FCFF is appropriate when the firm has substantial debt, fluctuating capital structure, or pays irregular dividends.
• FCFE is used when you are valuing equity from the viewpoint of a controlling or prospective owner able to direct cash flows.

Key Term: weighted average cost of capital (WACC)
The average after-tax required return for all providers of capital, weighted by their respective market values.

FCFF: CALCULATION APPROACHES

FCFF can be calculated starting from net income, EBIT, EBITDA, or CFO. The following are standard approaches:

• From net income:
  • FCFF = Net income + Non-cash charges + Interest × (1 - tax rate) – Fixed capital investment – Working capital investment
• From EBIT:
  • FCFF = EBIT × (1 - tax rate) + Depreciation – Fixed capital investment – Working capital investment
• From cash flow from operations (CFO):
  • FCFF = CFO + Interest × (1 - tax rate) – Fixed capital investment

Key Term: fixed capital investment (FCInv)
Net cash outflow for purchases of fixed assets, usually calculated as capital expenditures minus proceeds from sales of fixed assets.

Key Term: working capital investment (WCInv)
Change in non-cash working capital (current assets excluding cash and equivalents, minus current liabilities excluding short-term debt), reflecting capital tied up in operations.

FCFE: CALCULATION APPROACHES

There are two main methods to derive FCFE:

• From FCFF:
  • FCFE = FCFF – Interest × (1 - tax rate) + Net borrowing
• Direct from net income:
  • FCFE = Net income + Non-cash charges – Fixed capital investment – Working capital investment + Net borrowing

Key Term: net borrowing
The increase in a company’s debt, calculated as debt issued minus debt repaid during the accounting period.

Worked Example 1.1

Calculate FCFF and FCFE from Financial Statements

A company reports the following for the current year (in millions): Net income = $90; Depreciation = $20; Capital expenditures = $25; Increase in non-cash working capital = $5; Interest expense = $10; Tax rate = 30%; Net borrowing = $12.

Answer:

• FCFF = $90 + $20 + $10 × (1 - 0.3) – $25 – $5 = $90 + $20 + $7 – $25 – $5 = $87 million
• FCFE = $90 + $20 – $25 – $5 + $12 = $92 million

VALUATION MODELS

Firm Valuation: Using FCFF

Firm value is the present value of expected future FCFF discounted at the WACC:

Firm value $= \sum\_{t=1}^N \frac{\text{FCFF}\_t}{(1 + \text{WACC})^t}$

Equity Value $= \text{Firm Value} - \text{Market Value of Debt and Preferred}$

Equity Valuation: Using FCFE

Equity value is the present value of expected FCFE discounted at the required return on equity (r):

Equity value $= \sum\_{t=1}^N \frac{\text{FCFE}\_t}{(1 + r)^t}$

Both models support single-stage (constant growth) and multistage (variable growth) forms, analogous to dividend discount models.

Worked Example 1.2

Valuing Equity with FCFE

A firm’s expected FCFE next year is $5 per share and is expected to grow at 4% in perpetuity. The required return on equity is 10%.

Answer:
Equity value per share = $5 / (0.10 - 0.04) = $83.33

SPECIAL CONSIDERATIONS

• FCFF is preferred in scenarios with unstable financial gearing, recent recapitalizations, or substantial non-common-stock financing.
• FCFE is more sensitive than FCFF to financial gearing and debt payments when capital structure is volatile.
• Dividends, share repurchases, or share issues have no direct impact on FCFF or FCFE, but changes in financial gearing affect FCFE through net borrowing.

Exam Warning

FCFF should be discounted at the WACC. FCFE should be discounted at the required return on equity. Using the wrong discount rate is a frequent exam mistake.

ADVANTAGES AND LIMITATIONS

Advantages:

• Applicable to firms with no or irregular dividends
• Useful for controlling shareholders or potential acquirers
• Directly models value based on fundamental drivers of cash generation

Limitations:

• Sensitive to assumptions about growth, capital expenditures, and debt policy
• Accurate forecasting can be difficult, especially for firms in transition
• Multistage models require detailed year-by-year projections

Worked Example 1.3

Choosing Between FCFF and FCFE

Which valuation model is more appropriate for a highly leveraged company currently restructuring its debt?

Answer:
The FCFF model is generally better, since the firm’s future debt payments and capital structure are unpredictable, making equity cash flows more volatile.

Summary

Discounted cash flow models based on FCFF and FCFE are key tools for equity and firm valuation in cases where dividends are irregular, capital structures change, or the analyst requires a viewpoint reflecting all providers of capital or only equity holders. Accurate calculation of free cash flow, appropriate model selection, and careful forecasting are critical to correct application. Be vigilant for common exam mistakes, such as using the wrong discount rates or miscalculating capital investments.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish FCFF from FCFE and select the suitable model for the scenario
• Calculate FCFF and FCFE using net income, EBIT, EBITDA, or CFO
• Apply the proper discount rate for FCFF (WACC) and FCFE (cost of equity)
• Understand how capital structure, financial gearing, and net borrowing affect FCFE
• Recognize strengths and limitations of FCFF and FCFE models
• Identify when to use multistage versus single-stage DCF approaches

Key Terms and Concepts

• free cash flow to the firm (FCFF)
• free cash flow to equity (FCFE)
• weighted average cost of capital (WACC)
• fixed capital investment (FCInv)
• working capital investment (WCInv)
• net borrowing