What is Free Cash Flow to Equity (FCFE)?
The free cash flow to equity ratio measures the cash available to equity stockholders after costs, reinvestment, and debt payments. FCFE measures equity capital use.
Knowledge of Free Cash Flow to Equity
Free cash flow to equity includes net income, capital expenditures, working capital, and debt. Company income statements show net income. Capital expenditures are in the cash flow statement’s investment section.
The cash flow statement includes working capital in the cash flows from the operations column. Company working capital is the difference between its most recent assets and liabilities.
Short-term capital needs for immediate activities. The cash flow statement may include net borrowings in the finance section. Remember that net income includes interest expenditure, so you do not need to add it back.
Formula for FCFE
FCFE = operating cash minus Capex + net debt issued.
What Does FCFE Say?
Analysts use FCFE to value companies. This valuation approach became famous as an alternative to the dividend discount model (DDM), especially for dividend-free companies. While FCFE calculates shareholder availability, it does not guarantee shareholder payout.
FCFE helps analysts analyze if dividends and stock repurchases are financed by free cash flow from equity or other sources. Investors desire FCFE-paid dividends and share repurchases.
If FCFE is smaller than dividends and share buybacks, the corporation uses debt, current capital, or new securities, including retained earnings from earlier periods in existing capital.
Although interest rates are low, investors do not desire this in a current or prospective investment. Some experts believe borrowing to repurchase shares at a discount and at low speeds is brilliant. This only applies if the company’s share price rises.
When dividend payment funds are much less than the FCFE, the corporation uses the excess to raise cash or invest in marketable securities. Finally, the business pays investors all its money if they match the FCFE while buying back shares or paying dividends.
Example of FCFE Use
The Gordon Growth Model calculates equity value using the FCFE formula:
Vequity= (FCFE)/(r−g)
Where:
Vequity is the current stock value.
FCFE = anticipated next-year FCFE
Cost of equity of the company = r.
g = firm FCFE growth rate
This methodology calculates a company’s equity claim value if capital expenditure is less than depreciation and the stock’s beta is near one or less.
Conclusion
- Free cash flow to equity measures how much cash is accessible to equity stockholders after costs, reinvestment, and debt.
- Net income, capital expenditures, working capital, and debt comprise free cash flow to equity.
- Analysts use FCFE to value companies.
- FCFE became a popular valuation alternative to the dividend discount model (DDM), especially for companies that do not pay dividends.
