# FCFE (Free Cash Flow to Equity)  ## 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.

### Explained

FCFE or Free Cash Flow to Equity is one of the approaches (along with ) 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.

Learn to Calculate FCFE in Excel along with Alibaba FCFE Valuation

### FCFE Formula

#### Free Cash Flow to Equity Formula starting with Net Income.

For eg:
Source: FCFE (Free Cash Flow to Equity) (wallstreetmojo.com)

FCFE Formula = Net Income + Depreciation & Amortization + Changes in WC + Capex + 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 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.

###### 4) Capital Expenditure
• \$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 = \$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 . 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 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 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 .
• 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 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 (ke) and growth rates of FCFE.

### 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 , 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?

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. The company is reporting huge losses (Net Income is largely negative)
2. the company makes huge  resulting in Negative FCFE
3. Changes in working capital resulting in an outflow
4. 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.

### How dividends is different from Free Cash Flow to Equity

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 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)

### Recommended Articles

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!

1. 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.

2. 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

3. Than Aung says

Thank you so very much for your effort for providing this with comprehensive explanation. It’s really helpful and so useful.

• Dheeraj Vaidya says

Thanks Than. I am happy that you found this useful.

Best,
Dheeraj

4. Minh Quang says

Thanks a lot. I find it very helpfull :)

• Dheeraj Vaidya says

You are welcome!

5. 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

7. 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!

8. 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

9. Anklt Darolia says

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• Dheeraj Vaidya says

thanks Ankit!

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Keep up the good work Dheeraj Sir.

• Dheeraj Vaidya says

thanks Joel! I am glad you like the blog.

Best,
Dheeraj