# DCF Valuation Methods and FCFF vs FCFE

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 rate constant.

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)

So in equation No 1 we can replace EBIT*(1- Tax Rate) with PAT + Interest * (1 – tax rate)

Then the new equation for FCFF can be

• PAT + Interest * ( 1- Tax rate) + NCC – Change in WC – Capital expense

So we have following equations for calculating FCFF:

1. EBIT * (1 – tax rate) + NCC – Change in WC – Capital expense
1. PAT + Interest * ( 1- Tax rate) + NCC – Change in WC – Capital expense
• CFO + Interest * (1 – tax rate) + NCC – Change in WC – Capital Expense

In DCF valuation models, you will find first equation is most widely used. 2nd and 3rd equations are not that much used.

In FCFF approach, we use WACC as Discount rate and projected Free cash flows to firm are discounted using WACC. That PV is known as Implied Enterprise value. Then Non-Equity claims are deducted from Enterprise Value to arrive at implied equity value which is divided by diluted shares outstanding to arrive at implied share price which is also known as intrinsic share price.

1. Free Cash Flow to Equity (FCFE): It is that cash flow which is available to equity holders only after investing in working capital, capital expenditure and servicing debt.

Debt servicing included payment of Interest and repayment of debt of that particular period.

Formula to calculate FCFE:

1. EBIT * (1 – tax rate) – Interest*(1-taxrate) + NCC – Change in WC – Capital expense +/- debt borrowing

1. PAT + NCC – Change in WC – Capital expense +/- debt borrowing

• CFO – Capital Expense+/- debt borrowing

1. FCFF – Interest * (1 – tax rate) +/- debt borrowing

In DCF valuation models, Free Cash Flow to Equity is not that much frequently used. Generally you will see Free cash flow to Firm model because it is easy to calculate and it gives a broader picture of company compared to FCFE.

In FCFE approach, we use Cost of Equity (Ke) as Discount rate and projected Free cash flows to Equity are discounted using Ke to get the present Value (PV) of those cash flows. That PV is known as Implied Equity value.

Implied equity value is divided by diluted shares outstanding to arrive at implied share price which is also known as intrinsic share price.

Final thoughts on FCFF and FCFE:

So In FCFF model, Cost of Capital (WACC) is used as Discount Rate to get the Present Value. That pv is known as enterprise Value, then Non-Equity Claims are deducted from Enterprise Value to get Implied equity value which is further divided by diluted shares outstanding to get Fair value of share.

Where as in FCFE model, Cost of Equity (Ke) is used to get Present Value to get Implied Equity Value directly, which is further divided by diluted shares outstanding to get Fair value of Company share.

Where Non-Equity claims are calculated as follows:

Total Debt + Preferred Stock + Minority Interest + Lease – Cash & Equivalent

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