Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (2024)

Module 13.Integrated Financial Modelling

  1. 1Introduction to Financial Modelling
  2. 2Excel workbook setup
  3. 3Historical Data
  4. 4Assumptions (Part 1)
  5. 5Assumptions (Part 2)
  6. 6Revenue model
  7. 7Asset Schedule (Part 1)
  8. 8Asset Schedule (Part 2)
  9. 9Debt Schedule
  10. 10Reserves Schedule (Part 1)
  11. 11Reserves Schedule (Part 2)
  12. 12Projections
  13. 13Cash flow statement
  14. 14Valuation (Part 1) – Overview
  15. 15
  16. 16
  17. 17Weighted average cost of capital and Terminal Growth
  18. 18Discounted Cash Flow Analysis (DCF)

← PreviousChaptersNext →

15.1 – Building blocks

Picking up from the previous chapter, we discussed relative and absolute valuation concepts. At its core, three key inputs drive the absolute valuations –

    • The cashflow
    • The timing of the cashflow
    • The rate at which the cash flow gets discounted

Let us deal with the broader concept of cash flow in this chapter. Remember, starting from the previous chapter to maybe the next few, we only discuss the theory behind the valuation. Once we get to a stage where we understand the valuation concept well, we will build the valuation model and integrate it within the model we have built so far.

The cash flow that we refer to here is called the ‘Free Cashflow.’ Free here implies that the company is free to allocate the cash generated from its operations to whatever purposes the company thinks is best—extending the thought, who owns that cash that the company’s operations generate? To answer that, you need to think about the company from its funder’s perspective. A company gets funds from two sources, i.e., debt and equity.

The debt and equity holders together finance the assets of the company. Hence, the following equation represents a company –

Debt Holders + Equity holders = Assets of the company

In its simplest form, the debt and the equity holders finance assets, the assets, in turn, generate a cash flow for the company. So the cash generated by the company belongs to both these funders in proportion to their funding. Further, we value the cash flow by factoring in the cash flow timing and the discount rate to develop our sense of the company’s valuation.

The point to note here is that the cash generated belongs to the company, i.e., the Debt + Equity funders. The cash that belongs to the company is called ‘The free cash flow to the firm’ (FCFF). Or, from the free cash flow to the firm, you can deduct whatever cash is supposed to go to the debt holders and value only the cash flow that belongs to the equity holders, and that is called the ‘Free cash flow to Equity (FCFE).

15.2 – Free cash flow calculation

To calculate the free cash flow (FCFE or FCFE), we need to start all over from the P&L again. Don’t worry, I won’t do a P&L deep dive but rather quickly discuss the overview. It may perhaps help you jog your memory. Have a look at this –

The company’s business operations ideally should generate positive cash, which is also the company’s revenue. The company pays off the cost of goods sold from the revenue generated. After paying for the cost of goods sold, the company pays the sales and general administrative costs. Usually, both get clubbed as the ‘expenses’ of the company. After adjusting for this, the company is left with ‘Earning before the interest and Tax’ or the EBIT. EBIT is one of the key margin metrics we use to analyze a company.

From EBIT, interest is paid to get us to the Profit before tax or PBT. From PBT, the company pays the taxes due for the financial year and finally arrives at the company’s bottom line, i.e., Profit after taxes or PAT.

All the above is very intuitive, I guess. The point to note here is the source of free cash, irrespective of whether you look at it from the firm’s perspective or equity holder’s perspective starts with the company’s operations after adjusting for expenses and taxes. This implies that we can start figuring out the true ‘Free cash flow’ by starting with the company’s bottom line, i.e., the Profit after taxes (PAT). What do I mean by ‘true’ free cash flow? I’m talking about identifying all the non-cash expense and adding it back to the PAT to figure out the free cash flow.

The cost of goods sold part usually includes depreciation as well. Remember that depreciation is just an allocation of charge, and it is not an actual expense. It is an accounting entry. Likewise, amortization is also a non-cash expense; it is an accounting entry. The first step in calculating the free cash flow (irrespective of FCFE or FCFF) is to add back depreciation and amortization to PAT.

Think about deferred taxes; this too is not an actual expense, but instead, the company is deferring its tax payment to a later date. Given this, you can add back deferred taxes as well.

So we have –

PAT + Depreciation + Amortization + Deferred Taxes

Please think of the above equation as the starting cash position. We now have to account for changes in the company that consumes cash. The changes I’m referring to are working capital changes and changes in the fixed assets position of the company.

To keep the operations going, the company should spend on working capital. As you may know, working capital is the funds required to run the day-to-day operations of a company. Day-to-day operations like picking up raw material on credit by a vendor, receiving an advance from the customer, stocking inventory, etc., are all activities that come under the company’s working capital. The balance sheet equation of working capital is –

Working capital = Current Assets – Current Liabilities

Note, since both assets and liabilities are current, working capital is also current.

Assume the average working capital requirement of a company is 100Crs, but for whatever reason, the working capital requirement increases to 120Cr, then the additional 20Crs will have to be accounted for when calculating the free cash flow. It is reduced from PAT + depreciation + amortization + Deferred Taxes.

Likewise, if the working capital decreases to 80Crs, it frees up 20Cr for the company, added back to the free cash flow calculation.

Next up are the fixed assets of the company. The company must invest in fixed assets. The general opinion is that these fixed assets will help the company generate higher operating cash in the future. Usually, the company’s fixed assets spend is predictable, but just like the working capital changes, the changes in fixed assets should also get factored in.

Considering both the above, our free cash flow equation looks like this –

PAT + Depreciation + Amortization + Deferred Taxes – Change in working capital – change in fixed asset investments.

Now, here is an interesting bit. If you relook at this again –

When we start free cash flow calculation, we start with the PAT of the company. But before we arrive at PAT, we payout interest or the finance charges. Now, think about it, to whom does the interest payout belong to? It goes to the debt holders, which means that if you were to look at the free cash flow to the firm, then we also need to add back the interest to our free cash flow calculation. Hence, the equation now looks like this –

PAT + Depreciation + Amortization + Deferred Taxes + Interest charges – Change in working capital – change in fixed asset investments.

The above equation is the free cash flow to the firm or the FCFF. Now, from the free cash flow to the firm, if you separate the cashflow which portion belongs to the debt holders and that will leave you with the part that belongs to the equity holders, which can then get valued and get a sense of company’s valuation from the equity holder’s perspective.

Think about what the debt holders expect from the company? Unlike the equity folks, debt folks have a different payout expectation. The debt funders lend a certain amount (principal) to the company and expect the company to pay interest against the principal amount. At the end of the tenure, the debt holders expect the principal to be repaid in full. So from the free cash flow equation that we arrived at earlier, if we separate the principal repayment and the interest payments, we are left with the ‘Free cash flow to the Equity.’

I hope the above explanation is clear about arriving at both FCFF and FCFE. We will get into a more detailed description in the next chapter, especially when we implement the absolute valuation model within the financial model we are building. But for now, I intend to give you an overview of how various elements of valuation come together.

15.3 – Return expectations

We now have a broad overview of how to calculate the free cash flow to the firm and the free cash flow to equity holders. Let’s quickly understand the return expectation from the firm and equity holder’s perspective.

To get a sense of the return expectation of the firm, we should be clear about what the debt holders expect. The debt holders of the firm, as we discussed earlier, expect an interest payment against the principal amount, plus at the end of the tenure, they expect the principal itself to be repaid.

The firm has to satisfy the debt holders’ return expectations. But the firm also has equity holders, who will have a different return expectations. So when you are thinking about the firm’s free cash flow, then because the firm has both debt and equity holders, the return expectation of the firm should be such that it satisfies both debt and equity holders. If you build a valuation model based on FCFE, the cash flow is discounted with a blended rate, satisfying both the debt and equity holders.

Let me give you an example. Assume a company has 350Cr, of which debt is 125Crs, and the equity holders fund the balance 225Cr. The debt holders expect a 9% return, and the equity holders expect a 15% return. Why they expect what they expect is something we will discuss later. However, from the company’s point of view, it should generate a blended return to satisfy both, i.e., the expectation of the firm is the weighted average return –

= (9%*125) + (15%*225) / 325


The blended rate of return is also called the ‘Weighted cost of capital (WACC). We will discuss this later.

Think about the equity holder’s return expectation. The equity holders will expect a higher return than the debt holders because the equity holders take more risk. Equity holders expect at least the risk-free rate that prevails in the economy plus a risk premium for the additional risk (over the debt holders) that they take. The return expectation of equity holders is called, ‘The cost of capital’.

Cost of capital = Risk-free rate + Risk premium

Note that the cost of capital is always higher than the WACC. In this chapter, I’ve laid down the basic foundation for the FCFF and FCFE and touched upon the return expectation. In the next chapter, let us try and take a closer at the same.

Key takeaways from this chapter

    • A firm can be looked at as a combination of debt and equity holders
    • The debt and equity holders finance the assets of the company
    • To get the FCFF, we start with PAT and add back all non-cash expenses
    • From FCFF, we deduct interest and principal repayments to get FCFE
    • The weighted cost of capital is a blended rate, and it is the expectation of the firm
    • Cost of capital is what return expectation of the Equity holders
    • The cost of capital is always higher compared to WACC

← PreviousChaptersNext →

View all comments →
  1. Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (4)Parth says:

    June 12, 2022 at 10:18 pm

    I want to learn about financial modeling through your blog so,
    Can you please tell how many chapter is left to complete financial modeling course ?


  2. Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (6)parth says:

    June 13, 2022 at 6:58 pm

    can you please tell us at what is final date at which you can upload the complete course ?


    • Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (7)Karthik Rangappa says:

      June 14, 2022 at 11:23 am

      I don’t have a date as such, Parth. But it is my intention to finish as early as possible.


  3. Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (8)Prasad says:

    June 21, 2022 at 10:47 am

    Hello Sir, when will we able to download the soft copies of Mind over Markets and Financial Modelling?


    • Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (9)Karthik Rangappa says:

      June 21, 2022 at 11:59 am

      We won’t put up the PDF of mind over markets. FM, once it is complete.


  4. Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (10)Nithin Jacob says:

    June 22, 2022 at 8:17 pm

    Good day Karthik,
    You and the folks at Zerodha are doing a wonderful job and have personally impacted me a lot in my journey through financial literacy. I had a few questions which are as follows:

    1. Why can’t one use just the Cash from operations + Trade receivables as the FCFE perspective and for DCF analysis?
    2. In the “weighted average return” example, the denominator should be 350 right adding the two weighages of 125 and 225?

    Keep up the amazing work!


    • Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (11)Karthik Rangappa says:

      June 23, 2022 at 10:50 am

      1) Trade receivables is a sort of provision and not actual cash on hand right?
      2) Oh yes, that’s a typo 🙂


  5. Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (12)Vivek sharma says:

    June 27, 2022 at 11:41 pm

    Sir actually today I took your varsity basics stock market certification I completed it but there was a question where there is wrong answer ticked
    As we have to buy shares before ex dividend date to be eligible for dividend but there it is written before record date kindly check


    • Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (13)Karthik Rangappa says:

      June 28, 2022 at 10:46 am

      Ah, ok. Thanks for pointing that out, Vivek.


View all comments →
Post a comment
Valuation (Part 2) - FCFF & FCFE – Varsity by Zerodha (2024)


What is the 2-stage FCFE valuation? ›

The 2-stage FCFF sums the present values of FCFF in the high growth phase and stable growth phase to arrive at the value of the firm. The 2-stage FCFE sums the present values of FCFE in the high growth phase and stable growth phase to arrive at the value of the firm.

Is FCFF or FCFE used for valuation? ›

Summary. Discounted cash flow models are widely used by analysts to value companies. Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are the cash flows available to, respectively, all of the investors in the company and to common stockholders.

What is the DCF method in Zerodha? ›

We use a valuation technique called the “Discounted Cash Flow (DCF)” method to calculate the company's intrinsic value. The intrinsic value as per the DCF method is evaluating the 'perceived stock price' of a company, keeping all the future cash flows in perspective.

How do you calculate terminal value in Zerodha? ›

The “Terminal Value” is the sum of all the future free cash flow beyond the 10th year, also called the terminal year. To calculate the terminal value, we just have to take the cash flow of the 10th year and grow it at the terminal growth rate.

What is the 2 stage valuation model? ›

The two-stage DDM is a methodology used to value a dividend-paying stock and is based on the assumption of two primary stages of dividend growth: an initial period of higher growth and a subsequent period of lower, more stable growth.

What is the meaning of FCFE in valuation? ›

Free cash flow to equity is a measure of how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt are paid. FCFE is a measure of equity capital usage.

What if FCFE is higher than FCFF? ›

Free cash flow to equity (FCFE) can never be greater than FCFF. II is incorrect because FCFF is net of all operating expenses and net of all deductions that are necessary to maintain the operational efficiency of the plant and equipment.

What is the formula for FCFF valuation? ›

FCFF = EBIT *(1-tax rate)+ Depreiciation + Amortization + deferred taxes -- working capital changes -- investment in fixed assets (CAPEX).

How to calculate FCFE? ›

FCFE is calculated as Net Income + Depreciation and Amortization (D&A) – Change in Net Working Capital – Capital Expenditures (Capex) + Net Borrowing. FCFE represents the cash flow available to equity investors, and is thereby a levered metric, since non-equity claims were met.

Is DCF a good valuation technique? ›

DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won't be accurate. It works best only when there is a high degree of confidence about future cash flows.

What is the difference between NPV and DCF? ›

The main difference between discounted cash flow vs. net present value is that net present value subtracts upfront year 0 costs (in actual dollars estimated) from the sum of the present value of the cash flows. The discounted cash flow method doesn't subtract these initial costs that include capital expenditures.

How does Zerodha make money? ›

Zerodha charges a commission on all intraday trades. However, compared to full-service brokers that charge a percentage of the trade value, Zerodha limits its brokerage. They charge a full brokerage of ₹20 per transaction irrespective of how large the transaction is.

How to calculate account value in Zerodha? ›

What does account value on Console mean?
  1. Account Value = Cash Balance + Margins Blocked + Holding Value + Pledge Value + Long Options Value - Short Options Premium.
  2. 4 . Pledge holdings = Present Value of Pledge Holdings.
  3. 5 . ...
  4. 6 . ...
  5. Note: The Dashboard values will be correctly updated on Console every day at 6 AM .

What is the 2 stage discounted cash flow model? ›

This is called the 2-stage DCF model. The first stage is to forecast the unlevered free cash flows explicitly (and ideally from a 3-statement model). The second stage is the total of all cash flows after stage 1. This typically entails making some assumptions about the company reaching mature growth.

What are the 2 models of equity valuation? ›

Three major categories of equity valuation models are present value, multiplier, and asset-based valuation models. Present value models estimate value as the present value of expected future benefits. Multiplier models estimate intrinsic value based on a multiple of some fundamental variable.

What is the single stage FCFE model? ›

The single-stage FCFE model assumes that (1) FCFE grows at a constant rate (g) forever, and (2) the growth rate is less than the required return on equity. The single-stage FCFE Model is best suited for firms growing at a rate comparable to or lower than the nominal growth in the economy.

What does the two stage dividend growth model evaluate? ›

The two-stage dividend growth model evaluates the current price of a stock based on the assumption a stock will: grow at a fixed rate for a period of time after which it will grow at a different rate indefinitely.


Top Articles
Latest Posts
Article information

Author: Kerri Lueilwitz

Last Updated:

Views: 5999

Rating: 4.7 / 5 (67 voted)

Reviews: 82% of readers found this page helpful

Author information

Name: Kerri Lueilwitz

Birthday: 1992-10-31

Address: Suite 878 3699 Chantelle Roads, Colebury, NC 68599

Phone: +6111989609516

Job: Chief Farming Manager

Hobby: Mycology, Stone skipping, Dowsing, Whittling, Taxidermy, Sand art, Roller skating

Introduction: My name is Kerri Lueilwitz, I am a courageous, gentle, quaint, thankful, outstanding, brave, vast person who loves writing and wants to share my knowledge and understanding with you.