When to use FCFE or FCFF or Gordon's Model to Evaluate a company?

[sparta890]

Finance Student here!
Just like the title says. Under what conditions would you use FCFE,FCFF, or GM to evaluate a company?

 

[Aleksander Hansen]

Ask a fundamentals guy and he/she will say,"all the time"; ask a HF stat-arb algo-trader and he will laugh at you.
Very subjective. Depends on your strategy and objectives.

I think you can forget about Gordon's model though. Conceptually fine, but doesn't work like that In the real world.

 

[sparta890]

Well I'm preparing for a test, where we will be given a forecasted income statement and a balance sheet of a company. Then we have to calculate FCFE, FCFF, and Gordon's and out of the three we have to explain which one is better suited for the company. I just cannot seem to find the reasons behind using one or the other or under what terms will one be better than the other two.

 

[Aleksander Hansen]

Very crudely stated: FCFE if you are looking at it from the perspective of buying equity; FCFF for firm-wide valuation.

 

[sparta890]

Very crudely stated: FCFE if you are looking at it from the perspective of buying equity; FCFF for firm-wide valuation.

Thanks Aleksander. Much appreciated

 

[David Harper CFA FRM]

(I've never seen anybody actually employ a Gordon Growth model in practice, I've only ever seen in a textbook)

I personally prefer FCFF b/c it's a little easier to compute firm cash flows "top down" (you can get there from EBIT + adjustments) than equity flows, but the downside is you have to compute WACC, which is both a sensitive input and surprisingly variable.

I was curious what CFA text has to say about this:

"The two free cash flow approaches, indirect and direct, for valuing equity should theoretically yield the same estimates if all inputs reflect identical assumptions. An analyst may prefer to use one approach rather than the other, however, because of the characteristics of the company being valued. For example, if the company’s capital structure is relatively stable, using FCFE to value equity is more direct and simpler than using FCFF. The FCFF model is often chosen, however, in two other cases:

1. A levered company with negative FCFE . In this case, working with FCFF to value the company’s equity might be easiest. The analyst would discount FCFF to fi nd the present value of operating assets (adding the value of excess cash and marketable securities and of any other significant nonoperating assets to get total firm value) and then subtract the market value of debt to obtain an estimate of the intrinsic value of equity.
2. A levered company with a changing capital structure. First, if historical data are used to forecast free cash flow growth rates, FCFF growth might refl ect fundamentals more clearly than does FCFE growth, which refl ects fl uctuating amounts of net borrowing. Second, in a forward-looking context, the required return on equity might be expected to be more sensitive to changes in fi nancial leverage than changes in the WACC, making the use of a constant discount rate difficult to justify." -- source: http://www.amazon.com/Equity-Valuation-Institute-Investment-ebook/dp/B0034DGPO0

if it's helpful, i have a youtube video on FCFF & FCFE using radio shack @

 

[sparta890]

Thanks David! Your video led me to this wonderful website. Thanks for the detailed answer. It is exactly what I was looking for.