Free Cash Flow to Equity (FCFE) is a financial metric that measures how much cash generated by a company is available for distribution to its shareholders. Several investors use FCFE while valuing a company's stock. Often, a high FCFE indicates a greater potential for dividends and growth. Let us understand this concept in detail and learn how to use it while making investment decisions.
Understanding free cash flow to equity
FCFE shows the cash a company can pay out to its equity investors after accounting for all:
- Expenses
- Reinvestments
- Debt obligations
In other words, FCFE shows how much cash is generated by a company from its operations and given out to shareholders. FCFE is calculated using the following formula:
Free Cash Flow to Equity (FCFE) = Cash from Operations - CAPEX + Net debt issued
Where:
- Cash from operations
- This is the cash generated by a company's core business activities
- It sums up all the cash received from a company’s day-to-day operations
- CAPEX (Capital Expenditures)
- This represents the funds used to acquire and maintain physical assets such as property, buildings, or equipment.
- It is subtracted from FCFE because these are necessary investments to sustain and grow the business.
- Net debt issued
- This shows the net debt a company has raised after deducting all the debt repayments.
- It must be noted that:
- If a company issues new debt, it provides additional cash inflow, which is added to the calculation.
- Conversely, if the company repays debt, it is a cash outflow.
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What does FCFE tell you?
Free cash flow to equity provides a comprehensive picture of a company's ability to generate cash which can be distributed to its shareholders. Most investors compare FCFE to actual dividend payments and share repurchases. This comparison helps to understand:
- Are the payouts made to shareholders sustainable?
- Is the company managing its capital efficiently?
- How is the financial health of a company?
Let’s understand in detail and see how analysing FCFE helps you:
- Acts as a valuation alternative
- FCFE is often used as an alternative to the Dividend Discount Model (DDM), particularly for companies that do not pay dividends.
- By using FCFE, analysts estimate the value of a company.
- This valuation is based on a company’s ability to generate cash flow available to equity holders rather than relying solely on dividends.
- Indicates if the payouts are sustainable
- FCFE indicates the cash available to shareholders.
- But, it does not necessarily mean this cash is:
- Distributed as dividends
or - Used for share buybacks
- Distributed as dividends
- Thus, investors compare FCFE to:
- Actual dividend payments
and - Stock repurchases
- Actual dividend payments
- This comparison helps to determine if these payouts are supported by the company's free cash flow.
- Tells whether the company is generating enough cash flow
- Assume that a company's dividend payments and share buybacks exceed its free cash flow to equity.
- This situation shows that the company is funding these payouts using:
- Debt
- Retained earnings
- Issuing new securities
- Generally, this situation is viewed “unfavourably” by investors.
- That’s because it implies the company is not generating enough free cash flow to support its shareholders’ returns organically.
- Shows the efficiency of management:
- Say the funds spent by a company on share buybacks and dividends are approximately equal to the FCFE.
- This situation shows that the company returns all its available free cash flow to shareholders.
- Often, investors see this as a sign of efficient capital management.
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Example of how to use FCFE
Let’s consider a hypothetical example related to "ABC Ltd." and learn in simple steps how you can practically use free cash flow to equity:
Step I: Collect financial data
- To begin with, you obtained the necessary financial data from ABC Ltd.'s financial statements
- Assume that you found the following details:
- Cash from Operations (CFO): Rs. 500 crores
- Capital Expenditures (CAPEX): Rs. 150 crores
- Net Debt Issued (new debt issued minus debt repayments): Rs. 50 crores
- Also, you found that ABC Ltd. paid:
- Rs. 100 crores in dividends
and - Rs. 50 crores for share buybacks
- Rs. 100 crores in dividends
- This means the company paid Rs. 150 crores to its shareholders [Rs. 100 crores (dividends) + Rs. 50 crores (buybacks)].
Step II: Determine Free Cash Flow To Equity (FCFE)
- You calculated FCFE using this
formula: Free Cash Flow to Equity (FCFE) =Cash from Operations - CAPEX + Net debt issued
- Free Cash Flow to Equity (FCFE) =500 - 150+ 50
- Free Cash Flow to Equity (FCFE) =Rs.400 crores
Step III: Comparison with FCFE:
- You noticed that FCFE is Rs. 400 crores, which is more than the Rs. 150 crores paid out to shareholders.
- This indicates that ABC Ltd. is generating sufficient free cash flow to cover its dividend payments and share buybacks.
- There is a healthy surplus of Rs. 250 crores (400 - 150).
Step IV: Analysis and Interpretations
Based on the above calculations, you drew the following conclusions:
| Positive signal | Financial stability | Attractive investment | Strong growth prospects |
| ABC Ltd. has strong cash-generation capabilities. | The company is not relying on debt to fund shareholder returns. This indicates financial stability and prudent management. |
|
ABC Ltd. can reinvest surplus FCFE and grow its business operations. |
Conclusion
Free Cash Flow to Equity (FCFE) is a financial metric used by investors to assess a company's financial health and its ability to generate cash for shareholders. It is calculated by adding cash from operations and debt issued (net of repayments) minus capital expenditures. By calculating FCFE, investors can determine if a company has enough cash to cover dividends and share buybacks without relying on debt.
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