Free cash flow to equity (FCFE) is a financial metric which measures the amount of a company’s cash that is available to its owners. This cash is what is remaining after accounting for expenses, debt payments, and long term investments.
Calculating Free Cash Flow To Equity
Because FCFE represents the cash amount available to be paid out to a company’s owners, it is necessary that the calculation accounts for expenses which take priority over shareholders. Specifically, financial obligations and capital expenditures. This calculation demonstrates the hypothetical amount of cash a company could return to its owners. The formula for FCFE is below.
FCFE = Operating Cash Flow – CapEx + Net Borrowing
Where
Operating Cash Flow = (More info)
CapEx = Capital Expenditures
Net Borrowing = Debt Borrowing – Debt Retired
What Is Distinct About Free Cash Flow To Equity?
FCFE is similar to other free cash flow metrics. However, there are a few key distinctions. For example, unlike un-levered free cash flow, free cash flow to equity is levered meaning FCFE accounts for the outflow of cash to meet financial obligations. The distinction between traditional free cash flow and FCFE is that FCF represents the cash available to both owners and lenders whereas FCFE only represents the cash available to owners. This is why net borrowings are included in the FCFE equation as capital raised via debt may be distributed to owners.
What Can Free Cash Flow To Equity Be Used For?
As stated before, FCFE represents the amount of cash a company could hypothetically distribute to its owners. So, FCFE can be utilized to create real value to shareholders. Perhaps the most direct form of value creation is dividend issuance which is possible because of free cash flow to equity. Another way a firm can produce value to its shareholders is via share buybacks which indirectly creates value but, as opposed to dividends, is tax free. Perhaps the most indirect, and least guaranteed, form of value creation is reinvestments into operations. By allocating FCFE into operations, companies may develop new products or maintain current operations in the hopes of increasing future cash flows and thus increasing share price. In simple terms, FCFE can be used for several actions which are specifically preformed to benefit equity investors.
Free Cash Flow To Equity in Business Valuation
One way investors may utilize the FCFE metric is to gauge a business’s intrinsic value. Because FCFE represents the cash that could create value for owners, it would make sense for prospective investors to consider this metric. While FCFE analysis isn’t always the best choice for business valuation calculations, there are some instances in which it may be the choice metric.
Negative Free Cash Flow To Equity?
While a negative FCFE figure may be alarming, it is important to understand that there are multiple items that impact this result which may still benefit a firm. One of these items is large debt retirements. While meeting financial obligations is both necessary and beneficial, it may greatly decrease the amount of cash available to owners, at-least temporarily. Another potentially beneficial factor which could result in negative FCFE is large capital expenditures. Capital expenditures are necessary when growing a business but they will inevitably decrease the cash available to owners, temporarily. However, negative or decreasing FCFE very well could be a bad sign. If the reason for it is negative or unusually low net income. The bottom line is that it is important to understand what is affecting the amount of cash that should be available to shareholders.
Free Cash Flow To Equity Calculation Example
The following image shows FCFE being calculated via Microsoft Excel. The hypothetical calculation uses unusually low numbers for visual simplicity.
