Definition
Free Cash Flow to Equity (FCFE) is a measure of how much cash is available to the equity shareholders of a company after all expenses, reinvestment and debt repayment is taken into account. It is a financial performance indicator, used to determine the firm’s ability to pay dividends or buy back stock. It’s calculated by subtracting net capital expenditure, change in net working capital, and debt repayment from net income and adding net debt.
Key Takeaways
- Free Cash Flow to Equity (FCFE) evaluates how much cash can be given to equity shareholders after all expenses, reinvestments, and debt repayments are handled. It gives an insight into the firm’s financial health and its ability to satisfy shareholder claims.
- It is a measure of a company’s profitability that is more direct and less susceptible to manipulation than earnings per share because it focuses on real cash that the company generates. If a company has a positive FCFE, it suggests that the company has enough cash to pay its debts, invest back into its business, and return money to its shareholders.
- Investors and analysts use FCFE to evaluate if equity is being fairly valued when making investment decisions. Companies with higher FCFE tend to be attractive to investors as they generally have the capacity to yield higher returns to shareholders, often through dividends or share buybacks.
Importance
Free Cash Flow to Equity (FCFE) is a crucial financial indicator as it reflects the cash available to the equity shareholders of a company after all capital expenditures, debts, and working capital requirements are taken into account.
This metric essentially represents the net cash profit that a business can distribute to its shareholders.
Investors and analysts use this valuation measure to assess a company’s profitability and financial stability.
High positive values indicate robust financial health, suggesting that entities have sufficient surplus to invest, distribute dividends, or repay debt.
Therefore, FCFE plays a substantial role in investment decisions, equity valuations, and strategic financial planning.
Explanation
Free Cash Flow to Equity (FCFE) serves a crucial role in financial management by helping investors, analysts, or financial managers assess the financial health of a company. They use FCFE to determine the cash available to equity shareholders after all expenses, reinvestments, and debt repayments are covered.
Essentially, this figure represents the cash that could potentially be returned to shareholders as dividends or be retained for investment to foster growth if the company adopts a re-investment policy. Therefore, the metric provides insights about a company’s capability to sustain and increase dividend payments, its financial flexibility, and its ability to pursue expansion opportunities without depending on external financing sources.
Moreover, FCFE is widely used in equity valuation where it forms the fundamental element of Free Cash Flow models. One such model is the Free Cash Flow to Equity model (FCFE model), commonly employed to estimate a company’s intrinsic value by calculating the present value of projected FCFEs and the terminal value of the company.
By comparing the intrinsic value to the current market value, investors can identify overvalued or undervalued equities, thereby aiding their investment decisions. In sum, FCFE is not just a mere financial indicator; it is a tool that’s instrumental in investment analysis, strategic financial decisions, and valuation modeling.
Examples of Free Cash Flow to Equity
Apple Inc: Apple Inc., the tech giant, offered investors a clear view of its capital costs by showing its Free Cash Flow to Equity (FCFE). After accounting for all expenses and reinvestments, Apple regularly demonstrates impressive cash flows accessible to equity shareholders. The company’s reports often show high FCFE, indicating a strong ability to pay dividends, buy back stock or reinvest in its business.
General Motors: After the financial crisis of 2008, General Motors was a company with low FCFE, which can be a red flag for equity investors. The company was heavily in debt and struggling to cover its day-to-day operating expenses. This led to bankruptcy and subsequent government intervention which showed the importance of considering a company’s FCFE for predicting potential financial health crises.
Amazon: For several years during its growth phase, Amazon’s FCFE was typically low or even negative due to heavy investments in infrastructure, technology, and acquisitions. Where some may have seen this as a lack of profitability, others recognized it as Amazon reinvesting in its own growth. Now, Amazon’s FCFE is significantly higher, demonstrating the success of its strategy and its ability to generate income for shareholders.
FAQs for Free Cash Flow to Equity (FCFE)
What is Free Cash Flow to Equity (FCFE)?
Free Cash Flow to Equity (FCFE) is a measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment, and debt repayment have been handled. It calculates the equity cash flow available to be distributed amongst the shareholders.
How is FCFE calculated?
FCFE is calculated by taking Net Income, adding Depreciation & Amortization, then subtracting any Change in Working Capital and Capital Expenditure (CapEx). This tells us how much cash is generated after the company has paid off its necessary costs and expenditures.
What is the difference between FCFE and FCFF?
Free Cash Flow to Equity (FCFE) and Free Cash Flow to Firm (FCFF) are two types of financial measure. The difference lies in their recipients. FCFE reflects the net cash available to the company’s equity investors, after all expenses including debts are paid off. On the other hand, FCFF reflects the ability of a company to generate cash that is available to be distributed among both debt and equity investors.
Why is FCFE important?
Free Cash Flow to Equity is a crucial measure in finance because it gives a clear picture of a company’s ability to generate cash that is distributable among the stock holders. It helps investors in making decisions about buying, selling, or holding the equity of a company.
Is a positive or negative FCFE better?
A positive FCFE implies that the company has adequate remaining cash flow after business operations and investments, which can then be distributed to shareholders. On the other hand, a negative figure indicates that the company does not have sufficient cash flow and may need to seek additional financing. Therefore, from an investor’s perspective, a positive FCFE is better.
Related Entrepreneurship Terms
- Capital Expenditure: Also known as Capex, this refers to the funds used by a company to acquire, maintain, and upgrade physical assets such as property, buildings, technological equipment, and machinery.
- Net Borrowings: The difference between the amount of loan a company has borrowed and the amount it has paid back to the lenders.
- Firm Valuation: The process by which the monetary value of a company is determined. This usually takes into account the company’s assets, earnings, market value of equity, and potential for growth.
- Debt Repayment: The act of paying back money borrowed from a lender in accordance with the terms of a loan agreement.
- Dividend Payments: The payment distributed by a corporation to its shareholders, usually in the form of cash or additional shares of stock. The payment amount is determined by the company’s board of directors.
Sources for More Information
Surely, here are four reliable sources for learning more about the finance term “Free Cash Flow to Equity”:
- Investopedia – They offer comprehensive financial definitions and articles.
- Coursera – They provide various finance courses where this term might be extensively discussed.
- Khan Academy – This is a learning platform that includes instructional videos on various finance topics.
- Corporate Finance Institute – They provide detailed articles, courses and certifications in corporate finance, where this term is often used.
