When choosing a stock to purchase or re-evaluating one, it's vital to understand what's happening with the company's money. Free cash flow to equity (FCFE) can help you understand how effectively your company is using its equity capital, including whether dividends and stock buybacks were likely financed or the company just used its own funds for these transactions.
What is free cash flow to equity (FCFE)?
Free cash flow to equity is one type of financial analysis you can do on a publicly traded company. The goal of this calculation is to gain a better understanding of how the company uses its free cash flow, or the money it has left over after paying its bills.
With the help of an FCFE analysis, you can do things like gauge a company's value based on its current financial situation and better understand its financial health from year to year. Like many metrics, FCFE is most useful when used to compare period-to-period performance within a company, rather than comparing it with other companies that may be structured very differently.
The components of free cash flow to equity
There are four main components of the most basic free cash flow to equity calculation:
- Net income. Found on the income statement, this tells you how much money the company has made after deducting most expenses.
- Depreciation & amortization. This line item exists on the income statement under the expenses section, as well as on the cash flow statement in the cash from operations section.
- Capital expenditures. You'll find capex on the cash flow statement. These are usually large, infrequent expenses that are required for the company to remain in business.
- Change in working capital. Also located on the cash flow statement, change in working capital is in the cash from operations section. You can also calculate net working capital by subtracting current liabilities from current assets and then comparing different periods.
- Net debt. Net debt can be calculated from a company's balance sheet. Total short-term liabilities and long-term liabilities (both found in the liabilities section), then subtract cash and cash equivalents plus short-term investments (both found in the assets section) from that total.
Free cash flow to equity versus the dividend discount model
Both free cash flow to equity and the dividend discount model can be used to predict valuation. However, they're very different.
With the dividend discount model (DDM), you use the current dividend payments to help predict future dividend payments, which are then used to calculate a predicted future stock price. Basically, the assumption is that the stock's current value is equivalent to the sum of its future dividends when they're discounted back to present value.
Free cash flow to equity, on the other hand, is just a singular component of a more complex analysis when it comes to calculating what a stock should be worth. This metric actually shows how much money the company has likely borrowed, if any, to fund expenses such as dividends and stock buybacks.
FCFE may consider dividends, but it doesn't use that as the main focus of the equation. Therefore, it can be used on any stock, not just dividend payers.
Calculating free cash flow to equity
There are several ways to calculate free cash flow to equity, but we're going to use the method based on net income due to its relative simplicity. When calculating FCFE from net income, the formula is:
FCFE = net income + depreciation & amortization - capex - change in working capital + net debt
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Since you have all the numbers you'll need on the cash flow statement, you can simply pull them from there and plug them into the formula. These numbers are made up for a fictional company called XYZ, Inc.
Net income = $2 billion
Depreciation & amortization = $1.5 billion
Capital expenditures = $250 million
Change in working capital = $3.5 billion
Net debt = $500 million
Following the formula, you'll get:
FCFE = NI + D&A - CE - CiWC + ND
FCFE = $2 billion + $1.5 billion - $250 million - $3.5 billion + $500 million
FCFE = $250 million
This would tell you that your company has a positive free cash flow to equity, meaning it likely hasn't needed to borrow to fund its operations. If the number had been negative, borrowing would have almost certainly been involved for some kind of project or dividend payout.
From here, it's important to determine why that number is negative or positive -- what actions did the company take in the last year to create this situation?
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