Free Cash Flow to Equity (FCFE)

Measures the amount of cash a business generates and is available for distribution to shareholders after all financial obligations are accounted for. 

Free Cash Flow to Equity (FCFE) measures the amount of cash a business generates and is available for distribution to shareholders after all financial obligations are accounted for. 

Free cash flow to equity

It represents the cash remaining after the company resolves all of its operating expenses, re-investments, and financing-related outflows. In addition, it estimates the amount of cash a company can return to its shareholders via share buybacks or dividends. 

Free Cash Flow to Equity is a discounted cash flow valuation method used to calculate a stock's fair value

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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. 

Formula

Mechanics

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) 

Let's further examine each section of the equation:

The 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) are the funds that a company uses for physical assets (e.g., property, plant, and equipment, or (PP&E). It is typically used for a company's new projects or investments. 

CapEx includes building a new factory or purchasing a new piece of equipment.

Net debt 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 Calculation:

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

Example
Particulars2018 ($ million)2017 ($ million)
Depreciation and Amortization1215
Current Assets14575
Fixed Assets200220
Accounts payable2525
Short term debt3020
Long term debt2015

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

Example Use

Calculations

It can calculate equity value using a discounted cash flow (DCF). We will look at an example of this below

formula

Where:

  • Equity value = the present value of the stock
  • FCFE = the expected value for next year
  • r = the discount rate
  • t = time periods 

Discounted cash flow analysis is crucial because it estimates the amount of money an investor would receive from an investment in a company. The analysis also adjusts for the time value of money.

Analysis

One crucial aspect is that it estimates the amount of equity available to shareholders, but not necessarily the amount that ends up being paid out to shareholders. 

Data analysis

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.  

What is the Difference between FCFE and FCFF?

First, let's discuss simple Free Cash Flow (FCF). It measures a company's profitability after it accounts for cash outflows from operations and Capex.

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.  

It is important to note the two different types of Free Cash Flows. Free Cash Flow to Equity is referred to as Levered Free Cash Flow, while Free Cash Flow to Firm (FCFF) is usually called Unlevered Free Cash Flow. 

Leverage is another term used for debt, so "unlevered" FCF refers to the cash available to shareholders before the company makes its interest payments. 

In contrast, "levered" FCF refers to the cash available to shareholders after the company meets all its debt obligations. 

difference

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. 

Free Cash Flow To Equity and Valuation

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). 

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. 

Key Takeaways

  • FCFE represents the cash available to a company's equity shareholders after all expenses, reinvestments, and debt has been paid.
  • The main components are net income, capital expenditures, and net debt.
  • It is often used as a valuation method, particularly when an analyst attempts to value a company that does not pay dividends. 
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Researched and authored by Rachel Kim | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn