What is Free Cash Flow to Equity – FCFE?
Free cash flow to equity is a measure of the amount of free cash available to shareholders of a company after all expenses, reinvestment and debt have been paid. The FCFE is a measure of the use of equity.
The FCFE formula is
FCFE=Operating cash–Capex+Net debt issuedThe
How to calculate the FCFE
Free cash flow to equity is comprised of net income, capital expenditures, working capital and debt. The net result is located in the company’s income statement. Capital expenditures are found in the Cash flow from investments section of the cash flow table.
Working capital is also found in the cash flow table; however, it can be found in the cash flow of the operations section. In general, working capital represents the difference between the most common assets and liabilities of the business.
These are short-term capital requirements related to immediate operations. Net borrowings are also shown in the cash flow table in the Financing cash flows section. It is important to remember that interest expense is already included in net income, so you do not need to add interest expense.
What does the FCFE tell you?
The FCFE metric is often used by analysts to try to determine the value of a company. This valuation method has grown in popularity as an alternative to the dividend discount model (DDM), especially if a company does not pay a dividend. Although the FCFE can calculate the amount available to shareholders, it does not necessarily correspond to the amount paid to shareholders.
Analysts also use the FCFE to determine whether dividend payments and share buybacks are paid for with free cash flow through equity or some other form of financing. The investors want the dividend and the share buy-back to be paid entirely by FCFE.
If the FCFE is lower than the dividend payment and the cost of buying back shares, the company finances either by borrowing, or by existing capital, or by issuing new securities. Existing capital includes retained earnings made in previous periods.
This is not what investors want to see in an existing or potential investment, even if interest rates are low. Some analysts argue that borrowing to pay for share buybacks when stocks are traded at a discount and rates are historically low is a good investment. However, this is only the case if the company’s share price increases in the future.
If the company’s dividend payment funds are significantly lower than the FCFE, then the company uses the surplus to increase its cash level or to invest in marketable securities. Finally, if the funds spent on buying back stocks or paying dividends are roughly equal to the FCFE, then the company pays everything to its investors.
Example of use of FCFE
Using the Gordon growth model, the FCFE is used to calculate the equity value using this formula:
- Vequity = stock value today
- FCFE = FCFE expected for next year
- r = cost of the company’s equity
- g = growth rate in FCFE for the company
This model is used to find the value of a firm’s equity claim and is only appropriate if capital spending is not significantly greater than depreciation and if the beta of the firm’s shares is close 1 or less than 1.