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 Discounted Cash Flow valuationDiscounted Cash Flow ValuationDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.read more approaches (along with FCFFFCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.read more) 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.

FCFE and Debt Ratio

Most Important – Download FCFE Excel Template

Learn to Calculate FCFE in Excel along with Alibaba FCFE Valuation

FCFE Formula

Free Cash Flow to Equity Formula starting with Net Income.

FCFE (Free Cash Flow to Equity)

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

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

FCFE FormulaAdditional Comments
Net Income
(+) Depreciation & Amortization
(+/-) 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
(+/-) 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

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 SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more 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

FCFE Example

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.

FCFE - Changes in Working Capital
4) Capital Expenditure
5) Net Borrowings

Borrowings will include both the short term and long term debt

Free Cash Flow to Equity for 2016 comes out to be as per below –
FCFE Calculations

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 ValuationAlibaba IPO ValuationAlibaba is the most profitable Chinese e-commerce company and its IPO is a big deal due to its size. With its huge size and network, Alibaba IPO may look at international expansion beyond China and may lead to price wars and intensive competition in the US.read more. 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 ModelingLearn Financial ModelingFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more, 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)
Alibaba IPO FCFE Forecasts

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.
NPV FCFE Projectsions

Step 4 – Find Terminal Value

FCFE Terminal Value

Step 5 – Find the Present Value

Alibaba FCFE DCF

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.read more of Stock prices on FCFE inputs – Cost of Equity and Growth Rates.

FCFE Sensitivity Analysis

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. read more, 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.

FCFE and Debt Ratio

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 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.read more 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.

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.read more.

Box IPO - FCFE Borrowings

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)

Free Cash Flow to Equity Video

 

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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!

Reader Interactions

Comments

  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

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    • Dheeraj Vaidya says

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

      Best,
      Dheeraj

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    • Dheeraj Vaidya says

      You are welcome!

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    • Dheeraj Vaidya says

      thanks Ramesh!

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    • Dheeraj Vaidya says

      Thanks Sandeep. I am glad you find these articles useful.

      Best,
      Dheeraj

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    • Dheeraj Vaidya says

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    • Dheeraj Vaidya says

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      Not yet started writing on LBO Modeling. Will update you on this shortly.

      Thanks,
      Dheeraj

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    • Dheeraj Vaidya says

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    • Dheeraj Vaidya says

      thanks Joel! I am glad you like the blog.

      Best,
      Dheeraj