DCF Valuation Models: FCFF V/S FCFE

What is financial modelling

 

DCF Valuation Models: FCFF V/S FCFE

Discounted Cash Flow Valuation:

DCF is a fundamental technique of valuation which is based on the principle that the value of an asset will depend on the expected cash flows which the asset will generate in future.

Similarly the valuation of company will depend on all cash flows which the company will generate in the foreseeable future. DCF valuation gives the intrinsic value of the company which is equal to present value of those expected cash flows.

Higher expected cash flows will generate higher company value and lower expected cash flows will generate lower company value assuming other factors like Discount rateconstant.

There are various models in DCF valuation:

  1. Free Cash Flow methods : FCFF and FCFE 
  1. Dividend discount Model 
  1. Residual Income Approach 
  1. Economic Value added Approach

Free cash flow model is most widely used technique among DCF valuation approaches.

There are two different free cash flow models:

  1. Free Cash Flow to Firm (FCFF) Model: 
  1. Free Cash Flow to Equity (FCFE) Model:

Let’s understand both these models in detail now.

  1. Free cash flow to Firm (FCFF): It is that cash flow which is available to the firm (Debt +Equity)after investing in Working capital & Capital expenditure.

Formula to calculate FCFF:

EBIT * (1 – tax rate) + NCC - Change in WC – Capital expense

If you know EBIT – Interest = PBT

Then you also know that

(EBIT – Interest)*(1- Tax rate) = PAT

If you open this equation, You can write it as

EBIT * (1 – Tax Rate) = PAT + Interest * (1 – Tax Rate)



Best of luck.

Manoj Kumar

Senior Faculty

Investment Banking Institute

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