Free Cash Flow to Equity (FCFE)Defined along with formula and more

When you look at the cash balance that you find on a company’s balance sheet, do you think that it’s the balance that the company can freely distribute to its shareholders?

Or do you think that it’s simply just the cash balance that is readily available for use by the company?

If you think the latter, you’d be correct.

Though there are some cases where it’s also a yes for the former question.

You see, there are several factors that a company has to consider when distributing cash to its equity shareholders.

Ideally, a company would want to get the cash it will use for cash dividends from a particular source.

This source is its operating cash flow.

However, that same cash source may also be used for capital expenditures, which lessens the amount available for distribution.

Though, if the company really wants to declare and distribute cash dividends, there are still ways.

It may source some of its cash needs from existing debt and capital, or even a new equity issuance.

It isn’t the most ideal course of action though.

This is because it means taking out resources that the company could have used for its operations and capital growth.

Rather, a company would want to source all of its cash distributions to equity shareholders from its Free Cash Flow to Equity (FCFE).

In this article, we will be taking a look at one of the important metrics that gauge a company’s equity capital usage – Free Cash Flow to Equity (FCFE).

We will learn its definition as well as the formula we need to use to calculate.

We will also discuss its importance in the valuation of a company. By the end of this article, we should have a deep understanding of what FCFE is.

What is Free Cash Flow to Equity (FCFE)?

Free cash flow to equity (FCFE) measures how much cash a company has that is available to its equity shareholders.

It is the amount that remains after considering expenses, reinvestments, and any financing-related outflows (e.g. payment of debts).

Ideally, a company would want to source all the cash it will use for cash dividends or share buybacks from its FCFE.

Do note that just because it’s the available amount doesn’t mean that FCFE is the amount that will be paid out to a company’s shareholders.

Some of the FCFE may be used for more reinvestments such as investing in marketable securities or growing the company’s capital balance.

The company may even use more cash than the FCFE for cash dividends or share buybacks.

If the FCFE is less than the cash dividend distribution and/or cost of share buyback, then it would mean that the company is funding some of its cash needs with debt or existing capital (maybe even both).

This isn’t ideal as it would mean that the company would be eating away at its resources.

Some may even argue that borrowing money just to make cash distributions isn’t a good course of action.

If the FCFE is significantly greater than cash distributions, it could mean that the company is using the excess to invest in marketable securities.

It could also mean that the company just wants to increase its cash level.

Having too much excess though might mean that the company isn’t using its liquid resources that well.

If the FCFE is equal to the total of cash dividends and cost of share buybacks, then it simply means that the company is using it all to pay its equity shareholders.

Free Cash Flow To Equity (FCFE) as a Valuation Model

Analysts often use FCFE to determine the value of a company.

It is an alternative to the dividend discount model (DDM).

It’s especially useful if a company does not distribute any dividends.

After all, just because a company has the cash available doesn’t mean that it will use it for dividend distribution.

Analysts also use FCFE to determine if the cash used for dividends and share buybacks are paid for with FCFE or some other financial sources.

On the investors’ part, they would want to see all cash distributions be sourced from the company’s FCFE.

Like the DDM, the FCFE does have its own set of limitations.

For one, it’s only really useful if the company’s leverage is not volatile.

It’s not useful for companies that have constantly changing levels of debt leverage.

The FCFE Formula

There are many ways to calculate a company’s FCFE. We can derive from a company’s FCFF (free cash flow to firm), net income, EBITDA, etc.

The simplest formula would be the following:

FCFE = Operating Cash Flow – Capital Expenditures + Net Debt Issued

What makes this formula simple is that we can gather all the variables from a company’s statement of cash flow.

If the company doesn’t have any gain/loss from the disposal of an asset, new equity issuance, or dividends, its FCFE will be equal to its net cash flow.

Operating Cash Flow

The operating cash flow (or cash flow from operations) is the net cash inflow or cash outflow generated by the company’s operations.

It isn’t always equal to the company’s net income as there may be non-cash revenues and expenditures.

There are two methods to determine a company’s operating cash flow: the direct and indirect methods.

The direct method is as it says: it calculates operating cash flow by identifying all operating cash inflows and outflows. This method is useful for companies that use the cash accounting method.

The indirect method starts with the company’s net income. From there, all non-cash items are added back (e.g. depreciation and amortization).

Then, any adjustments in net working capital are also considered.

Capital Expenditures

Capital expenditures, or CapEX for short, refers to the money that a company uses to acquire, upgrade, and/or maintain long-term assets.

This includes both tangible (e.g. building, equipment) and intangible (e.g. patent, copyright) assets.

A company doesn’t make capital expenditures just for the sake of it as they are often in huge amounts.

Capital expenditures are often made to facilitate the operations of the company.

They may also be for a planned expansion or growth such as a new project.

Capital expenditures not only include the acquisition cost of the assets but they may also include significant repairs and maintenance expenses.

Net Debt Issued

Net debt issued refers to the net amount of debt issuances and debt payments.

This figure is positive if debt issuances exceed debt payments.

It’s negative if debt payments exceed debt issuances.