What is 'Free Cash Flow To Equity - FCFE'

Free cash flow to equity (FCFE) is a measure of how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt are paid. FCFE is a measure of equity capital usage. It is calculated as:

FCFE = Net Income - Net Capital Expenditure - Change in Net Working Capital + New Debt - Debt Repayment.

BREAKING DOWN 'Free Cash Flow To Equity - FCFE'

Free cash flow to equity (FCFE) is often used by analysts in an attempt to determine the value of a company. This method of valuation gained popularity as an alternative to the dividend discount model (DDM), especially if a company does not pay a dividend. Although FCFE may calculate the amount available to shareholders, it does not necessarily equate to the amount paid out to shareholders.

Components of the FCFE

Specifically, free cash flow to equity is composed of net income, capital expenditures, working capital, and debt. Net income is located on the company income statement. Capital expenditures can be found within the cash flows from investing section on the cash flow statement. Working capital is also found on the cash flow statement; however, it is in the cash flows from operations section. In general, working capital represents the difference between the company’s most current assets and liabilities. These are short-term capital requirements related to immediate operations. Net borrowings can also be found on the cash flow statement in the cash flows from financing section. It is important to remember that interest expense is already included in net income so you do not need to add back interest expense.

Valuation Using FCFE

Using the Gordon Growth Model, the FCFE is used to calculate the value of equity using this formula:

Vequity = FCFE/ (r - g)

where Vequity = value of the stock today

FCFE = expected FCFE for next year

r = cost of equity of the firm

g = growth rate in FCFE for the firm

This model is used to find the value of the equity claim of a company, and is only appropriate to use if capital expenditure is not significantly greater than depreciation and if the beta of the company's stock is close to 1 or below 1.

How to Interpret the FCFE

Analysts also use FCFE to determine if dividend payments and stock repurchases are paid for with free cash flow to equity or some other form of financing. Investors want to see a dividend payment and share repurchase that is fully paid by FCFE. If FCFE is less than the dividend payment and the cost to buy back shares, the company is funding with either debt or existing capital, or issuing new securities. Existing capital includes retained earnings made in previous periods. This is not what investors want to see in a current or prospective investment, even if interest rates are low. Some analysts argue that borrowing to pay for share repurchases when shares are trading at a discount and rates are historically low is a good investment. However, this is only the case if the company's share price goes up in the future.

If the company's dividend payment funds is significantly less than the FCFE, then the firm is using the excess to increase its cash level or to invest in marketable securities.

Finally, if the funds spent to buy back shares or pay dividends is approximately equal to the FCFE, then the firm is paying it all to its investors.

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