Free Cash Flow Analysis — FCFF, FCFE, Conversion Quality, and Owner's Earnings

FCFF (Free Cash Flow to the Firm) is the cash available to ALL capital providers — debt and equity — after all operating investments are funded. It is the correct starting point for enterprise DCF valuation (discounted at WACC). The most common construction path starts from EBITDA and adjusts downward:

FCFE is the cash available specifically to equity holders after all debt service obligations and all operating investments. It is the equity DCF input — discounted at cost of equity to get equity value directly:

• Why subtract after-tax interest? FCFF is computed before interest expense. Debt holders' claim is after-tax interest (interest is tax-deductible, so the true cost to the firm is the after-tax amount). Subtracting this from FCFF leaves what is available for equity holders.
• Why add net borrowing? When a company borrows new money, that cash inflow is available to equity holders (as long as it's not needed for investment already captured in FCFF). When a company repays debt, cash goes to debt holders — reducing what's available for equity.
• FCFE sustainability check: sustainable FCFE = FCFF − interest × (1−t) − mandatory principal repayments. If the company must repay $200M in debt this year but FCFF is only $180M, FCFE is negative — equity holders receive nothing and may face dilution to cover the gap. Dividends that exceed FCFE are funded from new debt or asset sales — unsustainable.
• Alternative starting point: FCFE = Net income + D&A − CapEx − ΔNWC + Net borrowing. This starts from the equity holder's existing earnings and adjusts for cash flows not in net income. Damodaran uses this form in The Little Book of Valuation.

FCF conversion rate (FCF ÷ Net income, or FCF ÷ EBIT) is one of the most powerful single-ratio screens for earnings quality. Healthy businesses consistently convert the majority of their GAAP earnings into cash:

In his 1986 Berkshire Hathaway letter, Buffett introduced 'owner's earnings' as his preferred measure of a business's true economic earnings power — what an owner of the business could sustainably extract without impairing its competitive position:

• Why owner's earnings differs from GAAP earnings: GAAP net income includes D&A (non-cash) but ignores CapEx (cash). Adding back D&A without subtracting CapEx overstates economic earnings. But subtracting all CapEx understates them if much is growth CapEx (discretionary investment for future value). Maintenance CapEx — the irreducible minimum to maintain existing capacity — is the correct deduction.
• Estimating maintenance CapEx: three approaches: (1) Use reported D&A as a proxy — works well for asset-light businesses where D&A approximates replacement cost; (2) For capital-intensive businesses, use management's own disclosed maintenance CapEx (sometimes disclosed in MD&A or investor presentations); (3) Use an industry benchmark (e.g., refining: maintenance CapEx ≈ 40–60% of D&A; software: maintenance CapEx ≈ 20–30% of D&A because product half-life is shorter than accounting life).
• Owner's earnings vs. FCFF: they are closely related but not identical. Owner's earnings keeps growth CapEx in the equation (management decides whether to invest or return it) while FCFF subtracts all CapEx. For businesses with highly discretionary CapEx, owner's earnings is a better 'normalized' figure. For DCF purposes, FCFF is the correct input because you separately model growth CapEx in the reinvestment assumption.
• Practical application — Buffett's Coca-Cola purchase (1988): at the time of purchase, Coke's reported earnings were approximately $1B. D&A ≈ $250M. Maintenance CapEx (mostly bottling infrastructure) ≈ $200M. Owner's earnings ≈ $1B + $250M − $200M = $1.05B — very close to reported earnings. Coke's asset-light syrup business generated D&A ≈ CapEx. The simplicity of the business (stable, low CapEx, high pricing power, no working capital investment needed) made owner's earnings easy to estimate and durable — exactly what Buffett was buying.