FCFF vs FCFE and Valuation

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Posted by Bob on January 09, 19101 at 08:46:31:

Discounted Cash Flow techniques.

Some background definitions:

CF is cash flow from continuing operations before capital expenditures.
FCF is uncommitted freely-available cash flow after capital expenditures to maintain operations at the same economic level.
FCFF is free cash flow to the total firm.
FCFE is free cash flow to the equity owners.
FCFCE is free cash flow to the common equity owners.

FCFF adjusted for debt, if any, gives FCFE.
FCFE adjusted for senior equity, if any, gives FCFCE.

For a firm with no debt and no preferred stock or any other senior equity issue, FCFF and FCFE and FCFCE are identical. This is the current situation for as Yahoo! Inc.


Valuation is a broad term that refers to different analyses from different perspectives. The proper analysis and perspective depends on the purpose of the valuation. Investment valuation applies to investment assets which include both physical assets (stuff) and financial assets (claims on stuff).

Physical investments in operating ventures or capital expenditures in major projects typically are considered as an incremental new start-up "firm" to avoid the sunk costs fallacy, regardless of the sources and costs of financing, to evaluate the return on assets and the return on total capital invested in the venture or project. Additional analysis can consider the costs of debt and equity capital and return on equity.

Financial investments or portfolio investments in stock, bonds, and other marketable securities are valued independently of the market. Market price is not value, pricing is not valuation, and pricing models are not valuation models. For example, any model that includes market beta for risk is a hybrid pricing model, not a valuation model. A model that uses Monte Carlo simulation to address uncertainty indpendently of market-generated factors is a true valuation model.

The Theory of Investment Value by John Burr Williams is the codification of first principles of intrinsic value. This classic in the sense of timelessness is divided into two books by the author, one about theory and the other about practical application of the theory:

Book I is Investment Value and Market Price.
Book II is Case Studies in Investment Value.

The out of date case studies in Book II are just as timely as when they were first published in 1938. Both the theory and practice of investment value apply to all investment assets, but the emphasis in this book is on marketable securities, and the perspective is the firms' owners.

Security Analysis by Graham and Dodd, is about the analysis of marketble securities with emphasis on book value, and the perspective is the firms' owners.

Valuation by Copeland, et al. is about the evaluation and management of investments in physical assets from the perspective of the firms' management with emphasis on net present value, a form of cost-benefit analysis. As made clear in the seminal study by A. A. Berle and G. C. Means (The Modern Corporation and Private Property, 1932), the unavoidable conflict of interests between owners and management creates an agency problem with accompanying agency costs.

As indicated by the title and table of contents of each of these books, they address different aspects of general valuation. They are complementary, not necessarily contradictory.

Anyone who is interested in learning about valuation can find these books at a library and read them from cover to cover. Then an informed decision can be made about whether or not to buy the books based on each reader's particular needs and interests.

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