Free Cash Flow to Equity (FCFE)

What Is Free Cash Flow to Equity (FCFE)?

Free Cash Flow to Equity (FCFE) measures the amount of cash a business generates and is available for distribution to shareholders after deducting capital expenditures and net debt repayments.

In addition, it calculates the actual cash available for distribution to shareholders via share buybacks or dividends. It is a component used in discounted cash flow valuation models to calculate a stock’s fair value.

It became more popular as an alternative to the dividend discount model (DDM), especially for cases in which a company does not pay a dividend.

FCFE is the amount of cash remaining solely for equity investors. For example, a company can use this leftover cash to fund the following:

1. Dividend Issuances: The company can pay cash dividends to its preferred and common shareholders.

2. Share Repurchases: This is when a company buys back shares to reduce the outstanding shares. This process reduces dilution and can temporarily and artificially increase a company’s share price. 

3. Re-Investments: A company can also reinvest the remaining cash into its business operations. Companies usually do this in hopes that it will increase their share price. 

All of these options are for the benefit of a company’s equity holders. 

The Formula for FCFE

Now that we understand what Free Cash Flow to Equity is, let’s look at how to calculate it. The formula is as follows:

Free Cash Flow To Equity = Cash From Operating Activities - Capital Expenditures - Net Debt Issued (Repaid )

Where

• Cash From Operating Activities (CFO): Refers to the first section of the cash flow statement. It focuses on the cash flows from a company’s business activities, including purchasing and selling merchandise and providing services. 
• Capital Expenditures (CapEx): These are the funds that a company uses for physical assets (e.g., property, plant, and equipment, or (PP&E). These are the funds that a company uses for physical assets, including both new projects and investments in existing assets like property, plant, and equipment (PP&E).
• Net debt: It measures how much debt a company carries on its balance sheet compared to its liquid assets.

Essentially, net debt represents the amount of cash that a company would have if it paid off all of its debt and the company had enough liquidity to satisfy its debt obligations.

Example of how to use FCFE

We’ve seen what the formula for FCFE is. Let us not implement it and check how we can actually use it for calculations.

The balance sheet for Company X is given below. We will use it to calculate the company’s FCFE.

The company’s net income for the year 2018 is $250 million. 

For 2018:

Net income = $250 million

Depreciation and Amortization is $12 million

Change in Working Capital: 

Difference in Current Assets = 75 - 145 =  -70

Difference in Current Liabilities = 25 - 25 = 0

So, the change in Working Capital is

(-70 - 0) = $-70 million

Change in Capital Expenditure is

(220 - 200) = 20

Net borrowings is the sum of short-term and long-term debt:

Difference in Short Term Debt = 30 - 20 = 10

Difference in Long Term Debt = 20 - 15 = 5

Net borrowings = Short Term Debt + Long Term Debt = 10 + 5 = $15 million

So,

FCFE = 250 + 12 - 70 - 20 + 15

Free Cash Flow To Equity = $187 million

What does FCFE tell you?

One crucial aspect is that it estimates the amount of equity available to shareholders and represents the cash that a company can return to its shareholders after all expenses, debts, and reinvestments have been accounted for.

But what does it tell us? Let’s take a look below:

• It can be used to analyze whether a company’s dividend payments and stock repurchases are financed with Free Cash Flow To Equity or a different form of payment. Investors find it ideal when a dividend payment or share repurchase is paid completely using this.
• If a company’s metric is less than the dividend payment and the price to buy back shares, the company is financing with debt, existing capital, or the issuance of new securities. 
• When a company’s metric is significantly more than its dividend payment funds, it uses the extra Free Cash Flow To Equity to grow its cash level or invest in other sellable securities.
• Lastly, if a company’s metric is equal to the amount it is spending to buy back shares and pay dividends, the firm uses its total Free Cash Flow To Equity to pay its investors.  

FCFE vs. FCFF

First, let’s discuss simple Free Cash Flow (FCF). It represents the cash generated by the company’s normal business operations after subtracting capital expenditures from its operating cash flow.

Unlike the metrics, EBITA, EBIT, and Net Income, FCF adjusts for capital expenditures and changes in cash due to operating assets and liabilities. Because of this, FCF is usually used for DCF analysis and valuing companies. 

Leverage is another term used for debt, so ‘unlevered’ Free Cash Flow (FCFF) refers to the cash generated by the company’s operations before accounting for interest expenses and taxes. 

In contrast, ‘levered’ Free Cash Flow (FCFE) refers to the cash available to equity shareholders after accounting for interest payments, debt repayments, and other obligations.

Understanding the differences between FCFE and FCFF is important because the discount rate and numerator of valuation multiples depend on the type of cash flow used to value a company. 

To clear up any confusion, let’s take a look at the table below to understand the difference between the two terms:

FCFE in Valuation

The distinction between Enterprise Value and Equity Value is critical when valuing a company. The Enterprise Value of a company is the value of the entire firm without considering its capital structure.

The Equity Value of a company is the firm’s value attributable to its shareholders, which includes any surplus cash and excludes all of the company’s financial obligations (e.g., debt).

Now, for valuation, remember:

• If you want to calculate a firm’s net present value (NPV) of equity, you will use FCFE
• Conversely, if you calculate a firm’s NPV of the enterprise, you will use FCFF

When using DCF valuation with FCFE, the discount rate is the equity cost—using this rather than FCFF may be preferable if the firm’s dividend policy is unstable or an investor possesses a controlling interest in the firm.   

In contrast, the discount rate for DCF valuation when using FCFF is the weighted average cost of capital (WACC). This discount rate incorporates the costs of the firm’s capital structure. 

This metric has gained popularity among analysts for valuation using the dividend discount model (DDM). The FCFE makes valuation particularly easier if a company does not pay dividends. 

Researched and authored by Rachel Kim | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Discounted Cash Flow (DCF)
• Dividend Discount Model
• Economic Value Added (EVA)
• Free Cash Flow (FCF)
• Net Present Value (NPV)