Most people invest in the stock market to ensure that they can earn a stable source of income through dividends. Companies that provide dividends to their shareholders are usually profitable. You can determine whether or not a company is profitable through its financial statements and by checking its free cash flow. Free cash flow is the surplus cash that a company generates after fulfilling all the necessary operations expenses. But there is another technical aspect of investments that is just as crucial – free cash flow to equity. Here’s a detailed guide to help you understand it.

What is free cash flow to equity?

Free cash flow to equity, also referred to as FCFE is a corporate finance term, which is simply a metric for the amount of cash that can be distributed to a given company’s equity shareholders in the form of stock buybacks or dividends. This amount is calculated after all the necessary expenses, including fulfilling all operational needs, capital expenditure, reinvesting into the company, and paying off outstanding debts and other such expense obligations. FCF to equity is also regarded as ‘leveraged free cash flow’ and ‘flow to equity’ or FTE. While dividends are typically the cash flows that are paid to the shareholders of the company, FCFE is the amount of cash flow that is available to pay the dividends to the shareholders.

Free cash flow to Equity Formula

To derive a company’s FCFE details, you can refer to its statement of cash flows, available on their website. Many companies also send quarterly, semi-annual or annual reports of their financial statements. However, you can calculate the FCFE with the simple free cash flow to equity formula mentioned below:

FCFE = Cash from Operating Activities – Capital Expenditures + Net Debt Issued (Repaid)

Free cash flow to equity calculation – how it works

As is apparent from the formula mentioned above, FCFE comprises of metrics such as net income, the working capital and the capital expenditures as well as debt. If you intend to calculate FCFE, you should know how to read the financial statements released by the company and where you can find the numerical details. Here’s where you can find those details in the financial statements:

1. You can find the net income in the income statement of the company

2. Details about capital expenditure are listed in the cash flow statement under the section titled ‘cash flows from investing’.

3. Details about the working capital are also listed in the cash flow statement under the section titled ‘cash flows from operations’. Note that working capital generally signifies the difference between a company’s most recent assets and its liabilities.

4. Companies often have short term capital requirements that are typically related to immediate operations. These amounts are known as net borrowings or debts, and you can find the details of the same in the section labelled ‘cash flows from financing’ in the cash flow statement. Also, note that the interest expenses are already included in the net income section, which is why you do not have to add the expenditures associated with back interest.

Free cash flow to equity valuation and analysis – what it tells you

Financial analysts typically use the free cash flow to equity metric while attempting to determine the company’s value. This valuation technique became prevalent as it was regarded as an alternative or substitute to the then-popular Dividend Discount Model or DDM, especially in case certain companies did not provide dividends to their shareholders. As such, while the FCFE model calculates the amounts that are offered to shareholders, it does not equate the amounts paid out to them. Analysts also use the free cash flow to equity formula to determine whether stock repurchases and dividend payments are paid for with FCFE or other forms of financing. Remember that investors wish to see share repurchases and dividend payments which are fully funded by free cash flow to equity.

Essential factors to consider while analysing FCFE

There are three vital factors that you should consider while analysing FCFE. They are as under:

1. In case the FCFEis less than the cost to buy back shares or make dividend payments, it demonstrates that the company is probably being funded by the existing capital (including retained earnings from previous periods) or debt, or it is issuing new securities. As an investor, this is not something you wish to see in your prospective or current investment, even if the rate of interest is low. However, analysts may argue that taking on debt to pay for share repurchases, primarily when shares are being traded at discounted rates; could prove to be a good investment. But you should consider this only if the share prices of the company increase in future.

2. If the dividend payment funds of the company are considerably less than its free cash flow to equity, then it signifies that the fact that the company is utilising the excess funds to increase the level of cash. The company could also be investing in marketable securities.

3. Lastly, if the company is spending funds to pay dividends or buy back shares, and the amounts spent are approximately equal to the FCF to equity, then it demonstrates the fact that a company is performing well and paying all its investors.

What is negative FCFE?

An important fact to know about FCFE is that it can also be negative. A negative FCFE signifies that the company may need to raise funds or earn new equity; either immediately or sometime shortly. There are a few ways to understand if a company may be prone to negative FCFE before investing. They are as under:

1. If you see substantial negative net income in the financial statements, it is an indicator of negative FCFE.

2. Growth companies, especially in their early years, have various needs such as reinvestment, significant capital expenditure, hiring needs etc., which may, in turn, overwhelm their net income and result in negative FCFE.

3. If you notice that a company is investing a large amount of cash in some years and nothing in the other years, then the FCFEcould be negative in the reinvestment period and positive in the other years.

Conclusion:

Now that you know all about FCFE, you can better understand financial statements. If you need any guidance regarding investment decisions, you can consult our experts at Angel Broking.