FCFE or Free Cash Flow to Equity model is one of the Discounted Cash Flow approaches (along with FCFF) to calculate the Fair Price of the Stock.
FCFE measure how much “cash” a firm can return to its shareholders and is calculated after taking care of the taxes, capital expenditure and debt cash flows.
In addition, FCFE model is very similar to the dividend discount model (which directly calculates Equity Value of the firm). Unfortunately, FCFE model has various limitations like Dividend Discount Model. For example, it is useful only in cases where the company’s leverage is not volatile and it cannot be applied to companies with changing debt leverage.
In this article, we discuss the following –
 FCFE Formula
 FCFE Example in Excel
 Determining the Stock Price using FCFE Model – Alibaba IPO Case Study
 When to use FCFE model?
 What is Negative FCFE?
 How FCFE is different from Dividends?
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FCFE Formula
FCFE Formula starting with Net Income
FCFE Formula = Net Income + Depreciation & Amortization + Changes in WC + Capex + Net Borrowings
FCFE Formula  Additional Comments 
Net Income 

(+) Depreciation & Amortization 

(+/) Changes in Working Capital 

() Capex 

(+/) Net Borrowings 

FCFE Formula Starting from EBIT
FCFE Formula = EBIT – Interest – Taxes + Depreciation & Amortization + Changes in WC + Capex + Net Borrowings
FCFE Formula Starting from FCFF
FCFE Formula = FCFF – [ Interest x (1tax)] + Net Borrowings
FCFE Example – Excel
Now that we know what FCFE formula is, let us look at an example to calculate Free Cash Flow to Equity.
In this example below, you are provided with the Balance Sheet and Income Statement of two years – 2015 and 2016. You may download the FCFE Excel Example from here.
Calculate FCFE for 2016
Solution –
Let us solve this problem using the Net Income FCFE Formula
FCFE Formula = Net Income + Depreciation & Amortization + Changes in WC + Capex + Net Borrowings
1) Find the Net Income
Net Income is provided in the example = $168
2) Find Depreciation & Amortization
Depreciation & Amortization is provided in the Income Statement. We need to add the 2016 Depreciation figure = $150
3) Changes in Working Capital
Below is the calculation for working capital.
 From the Current Assets, we take Accounts Receivables and Inventory.
 From Current Liabilities, we include the Accounts Payable.
 Please note that we do not take Cash and Short Term Debt in our calculations here.
4) Capital Expenditure
 Capital Expenditure = change in Gross Property Plant and Equipment (Gross PPE) = $1200 – $900 = $300.
 Please note that this is a Cash impact will be an outflow of 300
5) Net Borrowings
Borrowings will include of both the short term and long term debt
 Short Term Debt = $60 – $30 = $30
 Long Term Debt = $342 – $300 = $42
 Total Net Borrowings = $30 + $42 = $72
FCFE for 2016 comes out to be as per below –
As we note from above, calculating Free Cash Flow to Equity is fairly straightforward!
Why don’t you calculate the FCFE using the other two FCFE formulas – 1) Starting with EBIT 2) Starting with FCFF ?
Determining the Stock Price using FCFE
In one of my earlier financial modeling analysis, I did valuation of Alibaba IPO Valuation. Though the model is now a bit dated, it still is useful atleast from the point of view of learning FCFE and how the stock prices can be found using FCFE methodology.
You can download Alibaba FCFE for following the FCFE example below.
Step 1 – Please prepare a full integrated financial model of Alibaba.
To learn Financial Modeling, you can refer this Financial Modeling Course.
Step 2 – Find Projected FCFE for Alibaba
 Once you have prepared the financial model, you can prepare the template like below for FCFE calculation.
 In our case, we use the Net Income FCFE formula.
 Once you have all the line items projected using financial modeling, it is very simple to link (see below)
Step 3 – Find the present value of explicit forecast FCFE
 In order to find the value of Alibaba from 20152022, you need to find the present value of projected FCFE
 For finding the present value, we assume that the Cost of Equity of Alibaba is 12%. Please note that I have taken this as a random figure so as to demonstrate FCFE methodology. To learn more about Cost of Equity, please refer to Cost of Equity CAPM
 Here, you can use NPV formula to easily calculate the NPV.
Step 4 – Find Terminal Value
 Terminal value here will capture perpetuity value after 2022.
 The formula for Terminal value using FCFE is FCFF (2022) x (1+growth) / (Ke – g)
 Growth rate is the perpetuity growth of FCFE. In our model we have assume this growth rate to be 3%.
 Once you calculate the Terminal value, then find the present value of the Terminal Value
Step 5 – Find the Present Value
 Add the NPV of explict period and Terminal value to find the Equity Value
 Please note that when we perform FCFF analysis, the addition of these two items provides us with Enterprise value
 To the above Equity Value, we add Cash and other investments to find the Adjusted Equity Value
 Divide the Adjusted Equity Value by total number of shares outstanding to find the Share Price
 Also, note that my valuation using FCFF approach ($191 billion) and FCFE approach ($134.5 billion) are coming out to be different primarily due to random assumptions of cost of equity (ke) and growth rates of FCFE
Step 6 – Perform Sensitivity Analysis of Stock Prices.
You can also perform sensitivity analysis in excel of Stock prices on FCFE inputs – Cost of Equity and Growth Rates.
Where can you use FCFE
Damodaran advises that FCFE can be used under the following conditions –
1) Stable Leverage – As seen in this graph below, Starbucks and Kellogs have volative Debt to Equity Ratio and hence, we cannot apply FCFE valuation model in these companies. However, CocaCola and P&G have relatively stable Debt to Equity Ratio. In such cases, we can apply FCFE model to value the firm.
source: ycharts
2) Dividends not available or Dividends are very different from FCFE – In most of the high growth companies like Facebook, Twitter, etc do not give dividends and hence, Dividend Discount Model can’t be applied. You may apply FCFE valuation model for such companies.
What is Negative FCFE?
Like Net Income, FCFE can also be negative. Negative FCFE can happen due to any or combination of the factors below –
 Company is reporting huge losses (Net Income is largely negative)
 Company makes huge capital expenditure resulting in Negative FCFE
 Changes in working capital resulting in an outflow
 Debt is repaid resulting in large cash outflow
Below is an example where we find Negative FCFE. I had earlier evaluated Box IPO and you can download its Box financial model here.
We note that in Box Inc, the main cause for Negative FCFE is Net Losses.
How dividends is different from FCFE
You can think of FCFE as “Potential Dividends” instead of “Actual Dividends”
Dividends
 A part of the earnings each year may paid to the shareholder’s (dividends payout) and the remaining amount is retained by the company for future growth.
 Dividends depends on the dividends payout ratio and mature/stable companies do try to follow stable dividend policy.
FCFE
 FCFE is basically the free cash available after all the obligations have been taken care of (think of capex, debt, working capital etc).
 FCFE starts with Net Income (before the dividends are deducted) and adds all the non cash items like depreciation and amortization. Thereafter, Capital expenditure required for company’s growth is subtracted. In addition, changes in working capital is also accounted for so as to successfully run the business in the operating year. Lastly, net borrowings (can be negative or positive) are added.
 FCFE is therefore “Potential Dividends” (leftover after all the stakeholder’s have been taken care of)
What next?
If you learned something new or enjoyed the post, please leave a comment below. Let me know what you think. Many thanks and take care. Happy Learning!
Alex says
Hi Sir, I wonder if FCFE should include refinancing from new equity issuance just as it includes net borrowing?
Dheeraj Vaidya says
Hi Alex, that’s an interesting question. What is the impace of new equity issuance on FCFE. The impact is none actually. The real impact comes on the per share value calculated.
1. new equity issuance means new shares issued.
2. FCFE is calculated as per the formula given in the post
3. Present value of FCFE is then dividend by the total number of outstanding shares to calculate the fair value of share.
Short answer > equity issuance leads to higher number of shares. Higher number of shares reduces per share value of the stock.
Albert Benny says
Hello Sir,
These are really helpful and amazing. I have a doubt sir, I had once come across an equity report from pubic website which had predictions including future sales(revenue) and costs depending on their expected customers and stuff like that. could you please tell us how do they come to such conclusions regarding such future market predictions and events?
Do you have any tutorials regarding such predictive models? I mean how to calculate the percentage increase in sales rather than taking an arbitrage vale. Do equity research analysts get access to details regarding the number of customers of a company which help them do more comprehensive analysis?
Thanks,
Albert
Dheeraj Vaidya says
Hi Albert, equity research analyst do a rigourous analysis on the company. All data that they use is publicly available. It’s just that they have to spend more time and energy on making sense from the information. Typical places where they look for relevant data is press releases, conference calls, industry reports, news, annual reports, company filings. In addition, they do have paid access to third party research tools like bloomberg, factiva etc that provide them with data in a structured and phased manner.
Thanks,
Dheeraj
Than Aung says
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Dheeraj Vaidya says
Thanks Than. I am happy that you found this useful.
Best,
Dheeraj
Minh Quang says
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Dheeraj Vaidya says
You are welcome!
Ramesh says
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Many thanks.
Dheeraj Vaidya says
thanks Ramesh!
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Dheeraj Vaidya says
Thanks Sandeep. I am glad you find these articles useful.
Best,
Dheeraj
Fay says
Hi Dheeraj
You are amazingly generous by sharing these with us.
I am learning a great deal and enjoy it thoroughly.
Very grateful.
Many thanks.
Dheeraj Vaidya says
Many thanks Fay!
Rakesh says
Hi Dheeraj….I would love to get your detail insight on LBO model
Dheeraj Vaidya says
Hey Rakesh,
Not yet started writing on LBO Modeling. Will update you on this shortly.
Thanks,
Dheeraj
Anklt Darolia says
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Dheeraj Vaidya says
thanks Ankit!
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Dheeraj Vaidya says
thanks Joel! I am glad you like the blog.
Best,
Dheeraj