What Is Free Cash Flow to Equity (FCFE)?
Free cash flow to equity (FCFE) is a crucial financial metric that measures the cash available to equity shareholders after the company has settled all its expenses, made necessary reinvestments, and paid off debts.
Understanding Free Cash Flow to Equity
Free cash flow to equity is derived from several components, including net income, capital expenditures, working capital, and debt:
- Net Income: Found on the company’s income statement.
- Capital Expenditures: Located within the cash flow statement under the investing activities section.
- Working Capital: Also situated on the cash flow statement, specifically in the operations section. It is usually the difference between a company’s current assets and current liabilities.
- Net Borrowings: Found in the financing activities section of the cash flow statement. Note that interest expenses are already included in net income and don’t need adjustment.
Key Takeaways
- Cash Measurement: FCFE calculates the cash available to equity shareholders after covering all expenses, reinvestments, and debts.
- Components: Composed of net income, capital expenditures, working capital changes, and debt issuance.
- Valuation Utility: Widely used by analysts to evaluate a company’s value, standing as an alternative to the dividend discount model (DDM).
- Flexibility: Essential for assessing companies that do not distribute dividends.
The Formula for FCFE
Below is the formula for calculating FCFE:
FCFE = Cash from operations - Capex + Net debt issued
What Does FCFE Tell You?
Analysts frequently use FCFE to gauge a firm’s value. This method gained traction as an alternative to the dividend discount model (DDM), especially for dividend-inactive companies. Although FCFE indicates the amount available to shareholders, it doesn’t necessarily reflect actual payments.
Analysts check whether dividend payments and stock buybacks are funded by FCFE or through other financing methods. Investors prefer dividends and repurchases fully covered by FCFE. If not, it suggests the use of debt, retained earnings, or issuing new securities.
Dissatisfaction arises if shareholders find that operations aren’t solely funding returns. Borrowing for stock repurchases might seem appealing, particularly with favorable interest rates, but only serves its purpose if share price escalates.
Should dividend payouts be lesser than the FCFE, this implies excess funds might inflate cash reserves or investments in marketable securities. Aligning dividend payouts with FCFE suggests full pass-through to investors.
Example of How to Use FCFE
Using the Gordon Growth Model, the FCFE aids in calculating equity value. Here’s the formula:
Vₑₜy = FCFE / (r - g)
Where:
- Vₑₜy = value of the stock today
- FCFE = expected FCFE for the next year
- r = cost of equity for the firm
- g = firm’s growth rate in FCFE
This model targets equity valuation, better suited if capital expenditures fairly equate to depreciation and if stock beta is around or below 1.
Embrace FCFE to make informed evaluations and understand the financial health of your investments!
Related Terms: Net Income, Capital Expenditures, Working Capital, Debt, Retained Earnings.
