What Is Free Cash Flow to Equity (FCFE)?
Free cash flow to equity is a measure of how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt are paid. FCFE is a measure of equity capital usage.
Understanding Free Cash Flow to Equity
Free cash flow to equity is composed of net income, capital expenditures, working capital, and debt. Net income is located on the company income statement. Capital expenditures can be found within the cash flows from the investing section on the cash flow statement.
Working capital is also found on the cash flow statement; however, it is in the cash flows from the operations section. In general, working capital represents the difference between the company’s most current assets and liabilities.
Key Takeaways
- A measure of equity cash usage, free cash flow to equity calculates how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt are paid.
- Free cash flow to equity is composed of net income, capital expenditures, working capital, and debt.
- The FCFE metric is often used by analysts in an attempt to determine the value of a company.
- FCFE, as a method of valuation, gained popularity as an alternative to the dividend discount model (DDM), especially for cases in which a company does not pay a dividend.
These are short-term capital requirements related to immediate operations. Net borrowings can also be found on the cash flow statement in the cash flows from financing section. It is important to remember that interest expense is already included in net income so you do not need to add back interest expense.
The Formula for FCFE
FCFE=Cashfromoperations−Capex+Netdebtissued
What Does FCFE Tell You?
The FCFE metric is often used by analysts in an attempt to determine the value of a company. This method of valuation gained popularity as an alternative to the dividend discount model (DDM), especially if a company does not pay a dividend. Although FCFE may calculate the amount available to shareholders, it does not necessarily equate to the amount paid out to shareholders.
Analysts use FCFE to determine if dividend payments and stock repurchases are paid for with free cash flow to equity or some other form of financing. Investors want to see a dividend payment and share repurchase that is fully paid by FCFE.
If FCFE is less than the dividend payment and the cost to buy back shares, the company is funding with either debt or existing capital or issuing new securities. Existing capital includes retained earnings made in previous periods.
This is not what investors want to see in a current or prospective investment, even if interest rates are low. Some analysts argue that borrowing to pay for share repurchases when shares are trading at a discount, and rates are historically low is a good investment. However, this is only the case if the company's share price goes up in the future.
If the company's dividend payment funds are significantly less than the FCFE, then the firm is using the excess to increase its cash level or to invest in marketable securities. Finally, if the funds spent to buy back shares or pay dividends is approximately equal to the FCFE, then the firm is paying it all to its investors.
Example of How to Use FCFE
Using the Gordon Growth Model, the FCFE is used to calculate the value of equity using this formula:
Vequity=(r−g)FCFE
Where:
- Vequity= value of the stock today
- FCFE = expected FCFE for next year
- r =cost of equityof the firm
- g = growth rate in FCFE for the firm
This model is used to find the value of the equity claim of a company and is only appropriate to use if capital expenditure is not significantly greater than depreciation and if the beta of the company's stock is close to 1 or below 1.
FAQs
FCFE is calculated as Net Income + Depreciation and Amortization (D&A) – Change in Net Working Capital – Capital Expenditures (Capex) + Net Borrowing. FCFE represents the cash flow available to equity investors, and is thereby a levered metric, since non-equity claims were met.
What is the difference between free cash flow to the equity FCFE and free cash flow to the firm FCFF )? ›
The FCFF method subtracts debt at the very end to arrive at the intrinsic value of equity. The FCFE method integrates interest payments and net additions to debt to arrive at FCFE.
How do you calculate free cash flow examples? ›
To calculate FCF, locate sales or revenue on the income statement, subtract the sum of taxes and all operating costs (listed as “operating expenses”), which include items such as cost of goods sold (COGS) and selling, general, and administrative costs (SG&A).
What is the two stage FCFE model? ›
The two stage FCFE model is designed to value a firm which is expected to grow much faster than a stable firm in the initial period and at a stable rate after that.
How to calculate terminal value for FCFE? ›
TV = (FCFn x (1 + g)) / (WACC – g)
- TV = terminal value.
- FCF = free cash flow.
- n = year 1 of terminal period or final year.
- g = perpetual growth rate of FCF.
- WACC = weighted average cost of capital.
FCFE is designed to estimate the cash flow that's available to equity holders, whereas FCFF takes into account both debt and equity holders. Additionally, FCFE assumes that a company doesn't issue or retire any debt, while FCFF doesn't make this assumption and considers a company's capital structure.
What is FCFE used for? ›
What Is Free Cash Flow to Equity (FCFE)? Free cash flow to equity is a measure of how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt are paid. FCFE is a measure of equity capital usage.
What is the best formula for free cash flow? ›
The formula would be: (Net Operating Profit – Taxes) – Net Investment in Operating Capital = Free Cash Flow. Subtract your required investments in operating capital from your sales revenue, less your operating costs, including taxes, to find your free cash flow.
What is the formula for free cash flow conversion? ›
The formula for calculating the free cash flow conversion (FCF) rate is as follows. Where: Free Cash Flow (FCF) = Cash from Operations (CFO) – Capital Expenditures (Capex) EBITDA = Operating Income (EBIT) + D&A.
What is the formula for calculating free cash flow? ›
The generic Free Cash Flow (FCF) Formula is equal to Cash from Operations minus Capital Expenditures. FCF represents the amount of cash generated by a business, after accounting for reinvestment in non-current capital assets by the company.
An example of FCFE would be a company that generated $100 million in cash from operations, spent $50 million on capital Expenditures, and had net borrowing of $10 million.
What is the single stage FCFE model? ›
The single-stage FCFE model assumes that (1) FCFE grows at a constant rate (g) forever, and (2) the growth rate is less than the required return on equity. The single-stage FCFE Model is best suited for firms growing at a rate comparable to or lower than the nominal growth in the economy.
Can free cash flow to equity be negative? ›
Like FCFF, the free cash flow to equity can be negative. If FCFE is negative, it is a sign that the firm will need to raise or earn new equity, not necessarily immediately.
How to calculate equity value? ›
Equity value is calculated by multiplying the outstanding shares by the market share price. Another way of calculating equity value is by subtracting the net debt from the enterprise value of the business.
How to calculate cash flow to shareholders? ›
Their calculation is similar to that of cash flow from assets. Cash flow to creditors is interest paid less net new borrowing; cash flow to stockholders is dividends paid less net new equity raised.
What is the difference between cash flow and FCFF? ›
Comparing Cash Flow vs. Free Cash Flow. Cash flow is seen as a straightforward measure of the net cash that came into or left the business during a given period of time. Free cash flow is a figure that tells investors how much cash your business has on hand after funding its operating and investing needs.
What is the difference between FCFF and net cash flow? ›
Free cash flow focuses on cash from operations minus capital expenditures. It measures how much cash is available for distributions after money invested to maintain or expand the business. Net cash flow looks at the total change in cash and cash equivalents based on all business activities.
What are the key differences between the free cash flows of a firm? ›
Firm free cash flows are computed using a subset of a firm's pro forma statements while project free cash flows use the entire financial statements. Firm free cash flows are actual values while project free cash flows are estimates.
