# Free Cash Flow to Equity

Updated on May 7, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

## What Is Free Cash Flow to Equity(FCFE)?

Free Cash Flow to Equity (FCFE) is the total amount of cash available to be distributed to the investors; that is, the company’s equity shareholders, which is the amount the company has after all the investments, debts, and interests are paid off.

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

FCFE value is obtained when the capital expenditures, debt obligations, and other expenses or cash outflows are deducted from the total cash flowing in the business. It is used as a substitute to Dividend Discount Model, letting individuals and institutions calculate the fair value of the company stocks.

### Key Takeaways

• Free Cash Flow to Equity (FCFE) represents the entirety of cash available to equity shareholders post-settlement of investments, debts, and interest obligations.
• FCFE computation encompasses net income as a starting point, integrating non-cash components like depreciation and amortization, deducting capital expenditure related to expansion, incorporating shifts in working capital, and considering net borrowings, whether positive or negative.
• The FCFE model calculates a company’s equity value like the Dividend Discount Model. However, its applicability is constrained, primarily serving firms with stable leverage and falling short when applied to entities experiencing varying debt structures.

### Free Cash Flow To Equity Explained

Free Cash Flow to Equity (FCFE) is one of the Discounted Cash Flow valuation approaches (along with FCFF) to calculate the Stock’s Fair Price. 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.

You can download this FCFE Calculation Excel Template here – FCFE Calculation Excel Template

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 cannot be applied to companies with changing debt leverage.

Free cash flow to equity is the valuation metric that helps investors be aware of the investment opportunities in a business. This is because it is derived after all the deductions that a firm needs to make to arrive at a figure that depicts its approximate profit figure over a period. This is what makes FCFE an important metric.

Though this is an important method of valuation for any business, it is recommended to companies to not depend on this solely to make any decision. It is always wise to evaluate and assess a business’s financial position by examining different factors using different methods. This, in turn, leads to wiser and smarter decision-making.

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### Formula

The formula used to calculate free cash flow to equity varies based on the information available for the computation.

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Let us see which formula is used when:

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

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

### Examples

Let us consider the following instances to understand the free cash flow to equity model properly:

#### Example 1

You can download this FCFE Calculation Excel Template here – FCFE Calculation Excel Template

Now that we know the FCFE formula 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 for 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
• 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

#### Example 2

On Nov 10, 2023, Wall Street conducted the two-stage free cash flow to equity method to figure out the fair value of the equity that industrial services firm SRG Global Limited held. The value estimated was AU\$1.33. The step was taken to indicate the investment opportunities that the company has.

In the process, it was found that the shares of the company were undervalued to up to 49% and it was also revealed that   the company peers traded the shares at a significantly lower rate.

### How To Calculate?

A series of steps is followed to calculate free cash flow to equity accurately. This is to ensure reliability of the value obtained. Let us check the calculation steps involved below using Alibaba as an example:

#### Step 1 – Prepare financial model

The first step towards calculating FCFE is to assess various aspects of a business and prepare a fully integrated model that can be comprehended easily.

#### Step 2 – Find Projected FCFE

• Once you have prepared the financial model, you can prepare the template 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 the detailed forecast Free Cash Flow to Equity.

• To find the value of Alibaba from 2015-to 2022, you need to find the present value of the projected FCFE.
• Please note that I have taken this as a random figure to demonstrate the Free Cash Flow to Equity methodology. For finding the present value, we assume that the Cost of Equity of Alibaba is 12%. 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 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. We have assumed this growth rate to be 3% in our model.
• Once you calculate the Terminal Value, 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.
• We add Cash and other investments to the above Equity Value to find the Adjusted Equity Value.
• Divide the Adjusted Equity Value by a total number of shares outstanding 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 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.

### When To Use?

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 to these companies. However, Coca-Cola and P&G have relatively stable Debt-Equity Ratios. We can apply the FCFE model to value the firm in such cases.

source: ycharts

2) Dividends are not available, or Dividends are very different from Free Cash Flow to Equity – In most high-growth companies like Facebook, Twitter, etc., do not give dividends. Hence, the Dividend Discount Model can’t be applied. You may apply the FCFE valuation model for such companies.

### Negative FCFE

Free Cash Flow to Equity can have a negative value. 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 Capex resulting in Negative FCFE
3. Changes in working capital result 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 Losses.

### Free Cash Flow to Equity vs Dividends

FCFE can be taken as Potential Dividends instead of Actual Dividends.. Let us see how they differ from each other:

###### Dividends
• Each year, a part of the earnings may be paid to the shareholders (dividends payout), and the company retains the remaining amount for future growth.
• Dividends depend on the dividends payout ratio, and mature/stable companies try to follow a stable dividend policy.
###### Free Cash Flow to Equity
• The free cash is 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. After that, the Capital expenditure required for the company’s growth is subtracted. In addition, changes in working capital are also accounted for to run the business in the operating year successfully. Lastly, net borrowings (negative or positive) are added.
• Free Cash Flow to Equity is, therefore, “Potential Dividends” (leftover after all the stakeholders have been taken care of)

### Free Cash Flow to Equity vs Free Cash Flow to Firm

FCFE and Free Cash Flow to Firm (FCFF) are two terms that play an important role in business valuation process. As they sound similar, many get confused and mistakenly use them as substitutes. Hence, it is expected from investors and firms to understand the difference between them clearly before evaluating businesses based on their respective values.

Listed below are the differences between free cash flow to equity valuation method and free cash flow to firm valuation method in brief:

• While FCFE is a levered cash flow, FCFF is an unlevered cash flow. This means that the former is the amount that is obtained after all financial obligations are deducted from the total money that a firm has, while the latter is the one that is yet to be adjusted to the financial obligations.
• In Discounted Cash Flow (DCF) valuation, FCFE computes the equity value of the company, which is also its intrinsic value. On the contrary, FCFF calculates the enterprise value.

### Free Cash Flow to Equity Video

1. What is the importance of FCFE?

Free Cash Flow to Equity (FCFE) is crucial for investors and analysts to evaluate a company’s financial health and assess its attractiveness as an investment. It represents the cash flow available to a company’s equity shareholders after deducting expenses and obligations.

2. What are the benefits of FCFE?

The benefits of FCFE include its focus on equity holders, helping them understand the cash flows they might receive. It aids in valuation, enabling a more accurate determination of a company’s intrinsic value and potential returns. FCFE also helps assess a firm’s ability to pay dividends, repurchase shares, or invest in growth opportunities.

3. What is the difference between FCFF and FCFE?

The key difference between FCFF and FCFE lies in the recipients of the cash flows. FCFF considers all investors, including equity and debt holders, and represents the cash generated from operations available to all stakeholders. FCFE, on the other hand, focuses solely on equity shareholders and represents the cash available to them after satisfying all obligations.

This article has been a guide to what is Free Cash Flow To Equity. Here, we explain the concept with formula, how to calculate it, examples, and FCFF. You may also look at the related articles below for a better understanding of the topic.

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

Very informative. You are indeed doing a yeoman service in disseminating such rich knowledge.

Many thanks.

• Dheeraj Vaidya says

thanks Ramesh!

6. SANDEEP KUMAR says

THANK YOU …IS VERY SMALL WORD FOR YOU DHEERAJ SIR, I ALWAYS WAIT FOR YOUR NEW TOPICS AND READ THEM AND TRY TO USE IT. YOU ARE DOING A VERY GREAT JOB FOR THOSE WHO ARE NOT ABLE TO TAKE CLASSES DUE TO SHORTFALL OF MONEY. THANK YOU THANK YOU SO MUCH DHEERAJ SIR.

• 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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excellent blog

• Dheeraj Vaidya says

thanks Ankit!

10. Joel Pinto says

Dear Dheeraj Vaidya Sir,
I sencerly appreciate you for all your efforts. You are truely fantastic person. Your materials are very easy to understand and very helpful. And unlike others, you aim to educate others and not make money.

Keep up the good work Dheeraj Sir.

• Dheeraj Vaidya says

thanks Joel! I am glad you like the blog.

Best,
Dheeraj