FCFE (Free Cash Flow to Equity)

What is FCFE (Free Cash Flow to Equity)?

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 dividend discount model (which directly calculates 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.

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?

FCFE Formula

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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
Net Income	Net Income is after the payment of Interest expense. Net Income can be taken directly from the Income Statement. You can also find this in the Cash Flow from Operations if the CFO is prepared using the In-direct method
(+) Depreciation & Amortization	Add back all the non-cash charges Generally, this number is found in the Income Statements. In some companies, Deprecation & Amortization head is not given separately as these expense gets included in Cost of Goods Sold, SG&A You can find Depreciation & Amortization figures from the Cash Flow statements (CFO)
(+/-) Changes in Working Capital	Please note that this cash is either an outflow or an inflow. Working capital primarily includes Inventory, Receivables, Payables. You may also include accrued liabilities in this formula. Short term debt is not included here in the changes in Working Capital
(-) Capex	Critical to determining CapEx levels required to support sales and margins in the forecast This number can be most easily located from Cash Flow from Investments. Please note that not only the Capital Expenditure is taken, we must also include “addition to intangibles”. Intangibles become important for software/knowledge-based businesses.
(+/-) Net Borrowings	Like working capital, this number can also be an outflow or an inflow This includes both the short term debt as well as the long term debt. Be sure to include the net figure i.e. Debt Issued – Debt Repaid.

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

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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 Free Cash Flow to Equity 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 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

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

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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 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 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 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 Cost of Equity, please refer to Cost of Equity CAPM
• Here, you can use the NPV formula to easily calculate the NPV.

Step 4 – Find Terminal Value

• The terminal value 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 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?

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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 Ratio 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.

source: ycharts

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?

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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  –

1. Company is reporting huge losses (Net Income is largely negative)
2. the company makes huge capital expenditure resulting in Negative FCFE
3. Changes in working capital resulting in an outflow
4. 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 Free Cash Flow to Equity

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You can think of FCFE as “Potential Dividends” instead of “Actual Dividends”

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 successfully run the business in the operating year. 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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