by Obaidullah Jan, ACA, CFA

There are a range of measures used to determine a company’s net cash flows for valuation purpose, but free cash flow is the most appropriate. Free cash flow is the cash flow each period that is left for distribution to providers of capital. Other cash flow measures include cash flow from operations (CFO), earnings before interest, taxes, depreciation and amortization (EBITDA), funds from operations (FFO), etc.

It is important to understand the definition of different cash flow measures and how we one can be converted to the other. It is because in finance and investment, the intrinsic value of each asset, i.e. a company, a project, a stock, a bond, a real estate, etc. equals the present value of its future cash flows. The measure of cash flow that we use in any valuation or analysis exercise must match our definition of value and the characteristics of the asset being valued.


EBITDA is sometimes considered a proxy for cash flow. It equals net income plus taxes plus interest expense plus depreciation and amortization. Because depreciation and amortization, the two very significant accrual-basis accounting expenses are added back to net income, EBITDA is less prone to arbitrariness of accounting estimates and policies.

EBITDA is not a perfect measure of cash flow. It is due to two reasons: (a) EBITDA doesn’t make adjustment for changes in working capital such as increase or decrease in current assets or liabilities and (b) it ignores interest expense and taxes which are significant outflows. Despite its weakness, EBITDA is a popular measure because it is easy to work out right from the income statement. It is also used in calculation of EV/EBITDA ratio.

Cash flow from operations (CFO)

Cash flow from operations equals the revenue receipts minus the payments made for operating expenses i.e. cost of sales, salaries, taxes, etc. It is also called cash flows from operating activities.

Cash flow from operations is reported on a company’s statement of cash flows. If no statement of cash flows is available, it can be worked out from balance sheet and income statement. It equals net income plus non-cash expenses minus non-cash gains plus decrease in current assets minus increase in current assets plus increase in current liabilities minus decrease in current liabilities.


Where CFO is cash flow from operations, NI is net income, NCE is non-cash expenses, NCG is non-cash gains and WC is net change in working capital, i.e. WC = decrease in current assets – increase in current assets + increase in current liabilities – decrease in current liabilities.

Free cash flow to firm (FCFF)

Free cash flow to firm is a measure of net cash available for distribution to the company’s stock-holders and debt-holders. The value of a company i.e. the value of both its equity and debt equals the present value of the company’s free cash flow to firm determined using the weighted average cost of capital of the company.

FCFF differs from EBITDA in that FCFF adjusts for changes in working capital, subtracts after-tax interest expense while EBITDA doesn’t.

FCFF can be determined from the cash flow from operations using the following equation:

$$ FCFF=CFO+I×(1-t)-FC $$

Where I is interest expense, t is tax rate and FC is the net capital expenditure for the period. FC equals the closing value of PPE and intangible assets plus depreciation and amortization expense – the opening balance of PPE and intangible assets.

By substituting CFO in the above equation, you can find out the direct formula for FCFF starting with net income (NI).

Free cash flow to equity (FFCE)

Free cash flow to equity is a variant of the free cash flow which determines the net cash flow available for distribution to just the company’s equity-holders. It different from the free cash flow to firm in that the FCFF is measure relevant for all investors (both equity and debt) and FCFE is relevant only for equity-holders. Further, the value of a company’s equity can be determined by discounting the FCFE using the company’s cost of equity while the FCFF when discounted at the WACC gives us the firm value.

$$ FCFE=FCFF-I×(1-t)+B $$

Where B equals net borrowing.

By substituting FCFF in the above equation, you can arrive at a direct formula for FCFE.

The following formula links EBITDA the most top-level cash flow measure with FCFF the most refined measure of cash flow:

$$ FCFF=EBITDA×(1-t)+D×t-WC-FC $$

The following equation the value arrived using FCFF and FCFE using a single stage growth model:

$$ (FCFF_0×(1+g))/(wacc-g)=(FCFE_0×(1+g))/(r-g)+MVD $$

Where FCFF0 and FCFE0 represent the free cash flow to firm and free cash flow to equity both at time 0, WACC is the weighted average cost of capital, r is the cost of equity, g is the growth rate and MVD is the market value of debt.

Funds from operations (FFO)

Funds from operations (FFO) is a measure similar to cash flows from operations which is used in valuation of real estate investment trusts.

AFFO stands for adjusted funds from operations, a measure also used in REIT valuation which is a similar to free cash flow to firm.