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As one of the most important financial indicators of the stock value of a company, free cash flow to firm is a concept that should be understood by all business owners and investors. After all, the value of a company’s stock is generally considered to be a summation of expected future cash flows. Furthermore, you can also expect to come across the concept of Free Cash Flow to Equity (FCFE), and understanding how to calculate FCFF and FCFE is a necessary skill for entry-level corporate financing.
What is free cash flow to firm?
Free cash flow to firm is a formula used to determine the amount of cash available to investors after a company has paid all business costs, invested in long-term assets – such as equipment – and invests in current assets, such as inventory. When the FCFF considers the amount of cash remaining for investors it will also include stockholders and bondholders as beneficiaries.
If a company's free cash flow to firm valuation is positive, it indicates that after all expenses, the company has cash stores remaining. However, if the free cash flow to firm valuation returns a negative result, then you have an indication that the company is unable to cover its costs and investments because the company was unable to generate enough revenue.
How to calculate free cash flow to firm?
The free cash flow to firm valuation is a crucial indicator of a company’s performance and quality of its operations. There is a basic free cash flow to firm formula that considers all cash inflows (revenues), outflows (expenses), and cash reinvestments when calculating how much money remains.
So, what does the free cash flow to firm formula look like? Take a look at this common equation for free cash flow to firm valuation:
However, this is not the only FCFF formula used to calculate free cash flow to firm. Consider an FCFF from EBIT formula that calculates earnings before interest (EBIT) and taxes against depreciation (D). Here is one way to calculate FCFF from EBIT:
Free cash flow to firm vs. Free Cash Flow to Equity
FCFF is not the only type of Free Cash Flow available to determine a company’s performance. There is also Free Cash Flow to Equity – also known as Levered Free Cash Flow. Understanding FCFF vs. FCFE is important since the discount rate and the valuation multiples numerator will depend on the designation of cash flow.
The biggest difference in FCFF vs. FCFE is that FCFE excludes interest expense and the impact of net debt issuance – or repayments.
Free cash flow to equity can be calculated in two ways:
Free cash flow to firm strategy
Stock prices are not always accurately priced, which is why investors should use the free cash flow to firm formula in their trading strategies. If you’re an investor looking to buy into the corporate bonds or public equity of a company, you’ll want to check the company’s free cash flow to firm valuation. Viewing the free cash flow to firm of a company will enable you to test whether the stock price has been valued fairly.
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