Intrinsic Value, Part 3: Two Types of Free Cash Flow
A short but important detour before the calculations begin.
In Part 1, we established that the value of a business is the sum of all the free cash flow it will generate in the future, discounted back to today’s dollars. Simple enough.
But before we can calculate anything, there’s one thing you need to know: there are two different versions of free cash flow, and we use them for different types of companies. Mixing them up would be like using the wrong measuring system halfway through a recipe — the math would still run, but the result would be wrong.
This post explains what the two versions are, why they exist, and which one we’ll be using for most of the series.
The Two Versions
Free Cash Flow to the Firm (FCFF) — This measures the cash a business generates for everyone who has a stake in it: both the shareholders (the people who own the stock) and the lenders (the banks and bondholders the company borrowed from). It’s the cash the entire enterprise produces before any of it is paid out to either group.
Free Cash Flow to Equity (FCFE) — This measures the cash that belongs specifically to shareholders, after the company has already paid its lenders. It’s what’s left over once interest payments are made and debt is managed.
Think of it like a rental property. The building generates rental income. FCFF would be the total rental income before the mortgage payment. FCFE would be what’s left after the mortgage is paid — what actually lands in the owner’s pocket.
Both measures are legitimate. The question is which one is appropriate for the company you’re valuing.
Why Two Versions?
For most companies — retailers, manufacturers, technology firms, healthcare companies, energy producers — debt is just a funding choice. The company borrows money to finance its operations and growth, but the debt is separate from the business itself. In these cases, it’s cleaner to value the whole business first (using FCFF), and then subtract the debt at the end to arrive at what the shareholders actually own. This is the approach we use for the vast majority of companies.
Banks and insurance companies are a different animal entirely.
For a bank, debt isn’t a funding choice — it’s the product. A bank takes in deposits from customers (which are a form of debt — the bank owes that money back), and lends it out at a higher interest rate. The spread between those two rates is how a bank makes money. You can’t separate the bank’s debt from its operations because the debt is its operations. Valuing the whole firm and subtracting debt at the end doesn’t work when debt is woven into every line of the income statement.
The same logic applies to insurance companies, where premiums (the money customers pay for coverage) are held as a kind of liability until claims are paid. The financial structure of the business is inseparable from how it generates value.
For these companies, we skip directly to the cash that belongs to equity holders — FCFE — and discount it at the rate shareholders require, rather than the blended rate for the whole firm.
Which One We’ll Use
The short answer: almost always FCFF.
Most companies you’ll encounter as an investor — and the vast majority of the companies we track and analyze — are operating businesses where debt is just part of the capital structure, not the product itself. FCFF is the right tool for all of them.
FCFE, and the separate valuation approach it requires for financial firms, will get its own series of posts later. We’ll cover it completely — it’s important, and it changes some of the math meaningfully. But layering two frameworks on top of each other at the start would only create confusion.
So for the rest of the Intrinsic Value series, we’re focused on FCFF. When we talk about “free cash flow” from here on, that’s what we mean unless we say otherwise.
A Quick Map of Where We’re Going
Here’s the full picture of what the FCFF calculation requires, so you can see how the pieces fit together before we start building:
- Free Cash Flow to the Firm — how to calculate it from the three financial statements every public company is required to publish
- Growth — where the growth rate comes from, and why it’s grounded in what the company actually does rather than what analysts predict
- The Discount Rate — how to measure the risk of a business and translate it into the rate we use to bring future cash flows back to today’s dollars
- Terminal Value — how to capture the value of everything beyond our five-year projection window
- The Final Number — putting it all together to arrive at an intrinsic value per share, and comparing it to what the market is charging today
That’s the complete framework. In the next post, we start building it.
Next: Part 4 — Calculating Free Cash Flow to the Firm. We’ll go line by line through the financial statements, show you where each number comes from, and build the formula from scratch.
— Jim