What is FCFE (Free Cash Flow to Equity)?

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 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.

In addition, Free Cash Flow to Equity model is very similar to the DDMDDMThe Dividend Discount Model (DDM) is a method of calculating the stock price based on the likely dividends that will be paid and discounting them at the expected yearly rate. In other words, it is used to value stocks based on the future dividends’ net present value.read more (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.

FCFE Formula

Free Cash Flow to Equity Formula starting with Net Income.

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FCFE Formula = Net Income + DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more & 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

  • 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 SoldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.
  • read more, SG&A You can find Depreciation & Amortization figures from the Cash Flow statements (CFO)

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 the FCFE formula let us look at an example to calculate Free Cash FlowFree Cash FlowFree cash flow is a measure of cash generated by a company after all expenses and loans have been paid, and it is calculated by subtracting capital expenditure from operating cash flow.read more 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 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

Net Income is provided in the example = $168

Depreciation & Amortization is provided in the Income Statement. We need to add the 2016 Depreciation figure = $150

Below is the calculation for working capital.

  • From the Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more, we take Accounts ReceivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year.

  • read more and Inventory.From Current Liabilities, we include the Accounts PayableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more.Please note that we do not take Cash and short-term debt in our calculations here.

  • Capital Expenditure = change in Gross Property Plant and EquipmentProperty Plant And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. read more (Gross PPE) = $1200 – $900 = $300. Please note that this is a Cash impact will be an outflow of 300

Borrowings will include both the short term and long term debt

  • Short Term Debt = $60 – $30 = $30Long Term DebtTerm DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company’s balance sheet as the non-current liability.read more = $342 – $300 = $42Total Net Borrowings = $30 + $42 = $72

As we note 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 and 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 by following the Free Cash Flow to Equity example below.

Step 1 – Please prepare a fully 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 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 valueTerminal ValueTerminal Value is the value of a project at a stage beyond which it’s present value cannot be calculated. This value is the permanent value from there onwards. read more 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 valueEnterprise ValueEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more.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 outstandingShares OutstandingOutstanding shares are the stocks available with the company’s shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner’s equity in the liability side of the company’s balance sheet.read more to find the Share PriceAlso, 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 equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more (ke) and growth rates of FCFE.

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.

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 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

  1. 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.

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  –

  • The company is reporting huge losses (Net Income is largely negative)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 FCFEChanges in working capital result in an outflowDebt 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 modelBox Financial ModelOn 24th March,2014, Online storage company Box filed for an IPO and unveiled its plans to raise US$250 million. The company is in race to be build the largest cloud storage platform and it competes with the biggies like Google Inc and its rival, Dropbox.read more 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.

How dividends are different from Free Cash Flow to Equity

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

  • 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 Video

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