Comparing FCFF and FCFE Approaches to Valuation

Warren Buffett does his homework. During the global financial crisis, investors around the world watched in fear as investments crumbled in value. But Buffet wasn't panicking. He knew which investments had free cash flow, and he invested wisely in stocks as the price dropped, making billions. Why do you think he wasn't worried?

Yes!

Not quite.

It's not just interest that makes free cash flow so important. Buffett knew that companies with positive free cash flow had funds available even after fixed capital and working capital expenditures. That's called __free cash flow to the firm__, which is the cash flow available to the company's capital suppliers after all operating costs have been paid and necessary investments in working capital and fixed capital have been made. It's also cash flow from operations, less capital expenditures.

So Buffett used FCFF to calculate the intrinsic value and put his money to work. In order to find the intrinsic value, he took the present value of future FCFF discounted at the weighted average cost of capital. $$\displaystyle \mbox{Firm Value} = \sum_{t=1}^{\infty}\frac{FCFF_t}{(1+WACC)^{t}}$$ Why do you think the weighted average cost of capital is used?

Actually no. The WACC may actually be a great annualized return, but that's not the reason it's used to calculate the intrinsic value.

That's right! As an investor, Warren Buffett wants to make sure that the company makes a return above the cost of its capital, so it's used to discount the future FCFF to the present. Once Buffet had the firm's value, he took that amount less the market value of debt to calculate the total equity value. So then to find the per-share value, he simply divided by the number of shares outstanding.

Not quite. WACC might be better than high-yield bonds, but that's not a good reason to use it to calculate the intrinsic value.

In theory, using FCFF valuation for calculating the value for equity investors is possible, but it can be complicated when integrating numerous cash flows available to all investors. That's why it's also referred to as the _indirect_ method. The _direct_ method for calculating equity cash flow is called __free cash flow to equity__. Free cash flow to equity is cash flow available to the company's holders of common equity after all operating costs, interest, and principal payments have been paid and necessary investments in working and fixed capital have been made. Another way to think of free cash flow to equity is cash flow from operations, plus receipts from bondholders, less capital expenditures and payments to bondholders.

So in Warren Buffett's case, FCFE might actually be a better formula to use to calculate the intrinsic value, but it really depends on the company. What's one situation where Warren might prefer FCFF over FCFE?

That's right! For a levered company with a changing capital structure, the best free cash flow method would probably be free cash flow to the firm because FCFF would better reflect the fundamentals of the company. FCFE wouldn't be a great choice because the leverage would impact the net borrowing amounts in the FCFE calculation. At other times, Buffett might prefer FCFF because a highly leveraged company doesn't have positive FCFE, so FCFF would better capture the overall value.

No, actually. While leverage isn't a great sign, positive FCFE means that either method can be used.

No. A large dividend indicates that funds are being returned to shareholders, so FCFE can be used to calculate the intrinsic value.

So while there are reasons to use FCFF over FCFE, Warren Buffett is widely known for preferring the cash flow method over other types of valuation models. And he's also known for preferring long-term mature companies, so that's why a __constant growth FCFE valuation model__ makes sense for him. A constant growth model is just like it sounds—it assumes that a company will compound at a single rate (_g_). $$\displaystyle \mbox{Equity Firm Value} = \frac{FCFE_0 \times (1+g)}{r - g}$$ The discount rate, r, is the required return on equity.

To summarize: [[summary]]

So for Buffett, free cash flow is king, and he's notorious for disliking other cash flow and earnings-related metrics such as EBIT and EBITDA. Why do you think he dislikes them so much?

No. EBIT and EBITDA don't include the impact from taxes.

Yes! Other financial metrics don't capture the various capital structures that impact free cash flows. Also missing are tax payments (EBIT) or funds from bondholders. In addition, Buffett is big on reinvesting capital back into the firm, another reason why he prefers cash flows.

Not quite. EBITDA excludes depreciation, which is an important non-cash charge.

These companies had the ability to pay interest on debt

These companies had excess money after paying all bills

It's a good annualized return

It's the company's cost to obtain capital

It's a better return than high-yield bonds

A levered company has positive FCFE

A company pays a large stable dividend

A levered company has a changing capital structure

They include the impact of taxes

They ignore various capital structures

They include the impact of depreciation

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