What is FCFE (Free Cash Flow to Equity)?
Free cash flow to equity is the total amount of cash available to the investors; that is the equity shareholders of the company, which is the amount company has after all the investments, debts, interests are paid off.
FCFE or Free Cash Flow to Equity is one of the Discounted Cash Flow valuation approaches (along with FCFF) to calculate the Fair Price of the Stock. It measures 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, Free Cash Flow to Equity model is very similar to the DDM (which directly calculates the Equity Value of the firm). Unfortunately, the FCFE model has various limitations, like the 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.
Free Cash Flow to Equity Formula starting with Net Income.
FCFE Formula = Net Income + Depreciation & Amortization + Changes in WC + Capex + Net Borrowings
|FCFE Formula||Additional Comments|
|(+) Depreciation & Amortization|| |
|(+/-) Changes in Working Capital|
|(+/-) Net Borrowings|
Free Cash Flow to Equity Formula Starting from EBIT
FCFE Formula = EBIT – Interest – Taxes + Depreciation & Amortization + Changes in WC + Capex + Net Borrowings
Free Cash Flow to Equity Formula Starting from FCFF
FCFE Formula = FCFF – [ Interest x (1-tax)] + Net Borrowings
FCFE Example – Excel
Now that we know what the 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 Free Cash Flow to Equity for 2016
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 AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc., we take Accounts ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. and Inventory.
- From Current Liabilities, we include the Accounts PayableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period..
- 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 EquipmentProperty Plant And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. (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 both the short term and long term debt
- Short Term Debt = $60 – $30 = $30
- Long Term DebtTerm DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability. = $342 – $300 = $42
- Total Net Borrowings = $30 + $42 = $72
Free Cash Flow to Equity 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 Free Cash Flow to Equity using the other two FCFE formulas – 1) Starting with EBIT 2) Starting with FCFF?
Determining the Stock Price using Free Cash Flow to Equity
In one of my earlier financial modeling analysis in excel, I did a valuation of Alibaba IPO Valuation. Though the model is now a bit dated, it still is useful at least 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 Free Cash Flow to Equity example below.
Step 1 – Please prepare a full integrated financial model for Alibaba.
To learn Financial Modeling, you can refer to 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 the 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 Free Cash Flow to Equity.
- In order to find the value of Alibaba from 2015-2022, you need to find the present value of the 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 Free Cash Flow to Equity methodology. To learn more about the Cost of Equity, please refer to the Cost of Equity CAPM.
- Here, you can use the NPV formula to calculate the NPV easily.
Step 4 – Find Terminal Value
- The terminal valueTerminal ValueTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards. here will capture the perpetuity value after 2022.
- The formula for Terminal value using Free Cash Flow to Equity is FCFF (2022) x (1+growth) / (Keg)
- The growth rate is the perpetuity growth of Free Cash Flow to Equity. In our model, we have assumed 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 an explicit 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 an 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 outstandingShares OutstandingOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet. to find the Share Price
- Also, note that my valuation using the FCFF approach ($191 billion) and FCFE approach ($134.5 billion) are coming out to be different primarily due to random assumptions of cost of equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns. (ke) and growth rates of FCFE.
Step 6 – Perform Sensitivity Analysis of Stock Prices.
You can also perform sensitivity analysis in excelSensitivity Analysis In ExcelSensitivity analysis in excel helps us study the uncertainty in the output of the model with the changes in the input variables. It primarily does stress testing of our modeled assumptions and leads to value-added insights. In the context of DCF valuation, Sensitivity Analysis in excel is especially useful in finance for modeling share price or valuation sensitivity to assumptions like growth rates or cost of capital. of Stock prices on FCFE inputs – Cost of Equity and Growth Rates.
Where can you use FCFE?
Damodaran advises that Free Cash Flow to Equity can be used under the following conditions –
1) Stable Leverage – As seen in this graph below, Starbucks and Kellogs have volatile Debt to Equity RatioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. , and hence, we cannot apply the FCFE valuation model in these companies. However, Coca-Cola and P&G have relatively stable Debt to Equity Ratio. In such cases, we can apply the FCFE model to value the firm.
2) Dividends not available or Dividends are very different from Free Cash Flow to Equity – 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 the FCFE valuation model for such companies.
What is Negative FCFE?
Like Net Income, Free Cash Flow to Equity can also be negative. Negative FCFE can happen due to any or a combination of the factors below –
- The company is reporting huge losses (Net Income is largely negative)
- the company makes huge CapexCapexCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. resulting in Negative FCFE
- Changes in working capital resulting in an outflow
- Debt is repaid, resulting in a 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 LossesNet LossesNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet..
How dividends is different from Free Cash Flow to Equity
You can think of FCFE as “Potential Dividends” instead of “Actual Dividends.”
- A part of the earnings each year may pay to the shareholder’s (dividends payout), and the remaining amount is retained by the company for future growth.
- Dividends depend on the dividends payout ratio, and mature/stable companies do try to follow a stable dividend policy.
Free Cash Flow to Equity
- It 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 noncash items like depreciation and amortization. Thereafter, the Capital expenditure required for the company’s growth is subtracted. In addition, changes in working capital are also accounted for so as to run the business in the operating year successfully. Lastly, net borrowings (can be negative or positive) are added.
- Free Cash Flow to Equity is, therefore, “Potential Dividends” (leftover after all the stakeholder’s have been taken care of)
Free Cash Flow to Equity Video
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