**Free Cash Flow to Equity (FCFE)**

The free cash flow to equity (FCFE) is the measurement of the part of the own resources left to be distributed among the partners after all expenses, reinvestments and debts have been paid in an organization. While dividends are cash flows actually paid to shareholders, FCFE is cash flow that is entirely available to shareholders.

FCFE is the cash flow from operations minus capital expenditures minus payments to (and plus receipts from) debt holders.

The way in which free cash fl ow is related to a company’s net income, cash flow from operations, and measures such as EBITDA (earnings before interest, taxes, depreciation, and amortization) is important: The analyst must understand the relationship between a company’s reported accounting data and free cash fl ow in order to forecast free cash flow and its expected growth. Although a company reports cash flow from operations (CFO) on the statement of cash fl ows, CFO is not free cash flow. Net income and CFO data can be used, however, in determining a company’s free cash flow.

**What is it for?**

The FCFE is a measure of the direct use of capital. The free cash flow statement prepared by the company helps in assessing the effectiveness of decisions made.

**Formula**

It’s calculated as follows:

FCFE= Net Income – Net Expenses – Change in Equity + New Debt – Debt Payments

Read also: Free Cash Flow (FCF) | Explanation, Method of Analysis, Examples, Questions, Answers

**Examples**

ABC company’s net income is US$10mm given a 10% net income margin assumption and $100mm in revenue.

Total Revenue = US$100 million

Net Income = US$10 million

Net Margin = 10%

Next, our D&A assumption of $5mm is added back since it is a non-cash expense, and then we subtract the $3mm in Capex and $2mm increase in NWC (Net Working Capital).

D&A = US$5 million

Capex = US$3 million

Increase in NWC = $2 million

That leaves us with $10mm, but then we must subtract the $5mm in debt paydown, which leaves us with $5mm as the FCFE.

FCFE = $5 million

**FCFE STABLE GROWTH MODEL (Excel)**

This model is designed to value the equity in a stable firm on the basis of free cashflows to equity, especially when they are different from dividends paid.

Assumptions in the model:

1. The firm is in steady state and will grow at a stable rate forever.

2. The firm does not pay out what it can afford to in dividends, i.e., Dividends ≠ FCFE.

**User defined inputs**

The user has to define the following inputs to the model:

1. Current Earnings per share

2. Capital Spending and Depreciation per share

3. Change in working capital per share

4. Desired debt level for financing working capital and capital spending needs.

5. Cost of Equity or Inputs to the CAPM (Beta, Riskfree rate, Risk Premium)

6. Expected Growth Rate in free cashflows to equity forever.

Please enter inputs to the model: | ||||

Current Earnings per share = | $5,45 | (in currency) | {You can input all the numbers for the aggregate company, if you so desire} | |

Capital Spending/share = | $2,00 | (in currency) | ||

Depreciation / share = | $1,75 | (in currency) | ||

Chg. Working Capital/share = | $0,60 | (in currency) | ||

Desired debt financing ratio = | 29,97% | ( in percent) | ||

Do you want to offset capital expenditures by depreciation in the future? | No | |||

The reinvestment rate based upon your inputs is computed to be | 10,96% | |||

Do you want to recompute this reinvestment rate based upon fundamentals? | Yes | |||

If yes, enter the return on equity that you expect this firm to have in perpetuity | 12% | |||

Desired debt financing ratio = | 29,97% | ( in percent) | ||

Are you directly entering the cost of equity? (Yes or No) | No | |||

If yes, enter cost of equity = | (in percent) | |||

If no, enter the inputs for the CAPM | ||||

Beta of the stock = | 1,1 | |||

Riskfree rate = | 7% | (in percent) | ||

Risk Premium= | 5,50% | (in percent) | ||

Expected Growth Rate = | 6% | (in percent) | The expected growth rate for a stable firm | |

cannot be significantly higher than the nominal | ||||

growth rate in the economy in which the firm | ||||

operates. It can be lower. |

This is the output from the Gordon Growth Model | ||||

Firm Details: from inputs on prior page | ||||

Current Earnings per share = | $5,45 | |||

-(1- Desired debt fraction) * | 70,03% | |||

(Capital Spending – Depreciation) | $3,29 | $2,30 | ||

-(1- Desired debt fraction) * | 70,03% | |||

∂ Working Capital | $0,60 | $0,42 | ||

Free Cashflow to Equity = | $2,73 | |||

Cost of Equity = | 13,05% | |||

Expected Growth rate = | 6,00% | |||

Gordon Growth Model Value = | $40,97 |

Growth rate | Value |

10,00% | $98,28 |

9,00% | $73,34 |

8,00% | $58,28 |

7,00% | $48,19 |

6,00% | $40,97 |

5,00% | $35,54 |

4,00% | $31,31 |

3,00% | $27,93 |

2,00% | $25,15 |

The Gordon growth model (GGM) assumes that a company exists forever and that there is a constant growth in dividends when valuing a company’s stock. The GGM works by taking an infinite series of dividends per share and discounting them back into the present using the required rate of return.

Please download the: FCFE table growth

Free Cash Flow (FCF) | Explanation, Method of Analysis, Examples, Questions, Answers

Sources: PinterPandai, Investopedia, CFA Institute