Free Cash Flow to Equity Valuation

Quick Summary
1. Calculate historical free cash flow to equity from accounting data
2. Calculate the historical debt ratio
3. Estimate the short-term growth rate
4. Estimate the long-term, sustainable growth rate
5. Project how long the initial period of high growth will last before transitioning to the final stable growth phase
6. Forecast future free cash flows to equity
7. Determine the firm equity value by discounting future cash flows at the cost of equity

1. Historical Free Cash Flow to Equity
Free cash flow to equity (FCFE) represents the cash available to be paid out to common stockholders (as dividends or stock buybacks) after meeting all reinvestment needs and paying all other suppliers of capital (namely, creditors). Otherwise stated, it measures potential dividends and buybacks, which often differ from actual cash flows to equity holders. Valuing equity using FCFE is preferred in cases where a firm’s dividend (or lack thereof) differs significantly from its capacity to pay. Using FCFE is a simpler and more direct  approach than using FCFF but should not be used when the company has a changing capital structure.

We can find FCFE by calculating it directly or by starting from FCFF (here), but then subtracting after-tax interest expenses and adding net new borrowing. For the few companies that have preferred stock dividends, this item should be subtracted from FCFE if starting with FCFF.

FCFE = Net income + Noncash charges – Investment in fixed capital – Investment in working capital + Net borrowing

FCFE = FCFF – Interest expense (1 – Tax rate) + Net borrowing

2. Debt Ratio
Some analysts simplify FCFE calculations by assuming that a percentage of incremental investments in fixed capital and working capital are financed by debt. This percentage is referred to as the debt ratio (DR). Note that this method assumes depreciation is the only noncash charge.

FCFE = Net income – (1 – DR)(Investment in fixed capital – Depreciation) – (1 – DR)(Investment in working capital)

There are different approaches to calculating the debt ratio when examining past periods. The most straightforward calculation – as defined in the CFA curriculum –  is debt as a percentage of debt plus equity. Capitalized operating lease amounts should be factored into the debt and equity values (here). Aswath Damodaran, on the other hand, advocates taking the average net debt issued over, say, 10 years and dividing by the average incremental fixed and working capital expenditures over the same period. Historical FCFE is then recalculated using the firm’s average debt ratio. Annual FCFE is smoothed out as a result but average FCFE over the period will still be the same. Cash acquisitions of other companies should be treated as capital expenditures when determining the historical average debt ratio.

3. Short-term Growth Rate
The expected short-term growth rate of FCFE is estimated as the product of the equity reinvestment rate (here) and the return on equity (here). Industry averages may provide a good indication of future reinvestment rates since reinvestment needs tend to decrease as firms grow and mature. To ensure the return on capital estimate is forward looking, review historical trends in ROE, industry averages, and the marginal return on assets.

FCFE short-term growth

If a company’s FCFE has grown at a constant rate and if the historical trend is expected to continue, then the historical growth rate may also be appropriate. Note that the growth rate in a FCFE model is frequently not the same as the growth rate for sales, net income, or FCFF. If FCFE is forecasted by its individual components rather than in aggregate, make sure that capital expenditures are internally consistent with the growth assumption by referring to the equity reinvestment rate formula.

4. Long-term Growth Rate
The long-term sustainable growth rate of a firm can be estimated as a function of the equity reinvestment rate and return on equity. However, the revised inputs should reflect the trends of mature industry peers in steady state. There are also real constraints on how high the stable growth rate can be. The long-run growth rate of a firm cannot be greater than the growth rate of the overall economy. If the company operates domestically, the growth rate cannot be in excess of the domestic economy. If the firm operates (or will operate) multi-nationally, the growth rate cannot be in excess of the global economy (or the weighted average of the economies that the firm operates in).

Since the Treasury bond rate converges on the growth rate of the economy in the long term, another simple rule of thumb is to keep the sustainable growth rate less than or equal to the riskless rate. The most likely scenario is that as firms mature they will have a growth rate lower than that of the economy. Be aware that firms may already be in a steady state.

5. Transition Period
Estimating how abruptly or gradually the initial high growth rate will converge to the stable growth rate depends on a firm’s size, current growth rate, and its competitive advantages. Firms with moderate advantages might preserve their high growth rate for 5 years while firms with strong advantages might maintain them for 10 years. Firms with very high growth rates will likely see their growth drop suddenly in the first two years and then gradually thereafter.

Constant growth models are used for firms already in stable growth. Two-stage models (high growth rate changing abruptly to stable growth) are best suited for companies where the initial growth rate is already very close to the stable growth rate. Three-stage models (high growth for a period and then gradually converges to stable growth levels) are good for companies with very high growth rates that will have a transition phase. N-stage models work best for firms that are young and changes are expected in each year.

6. Forecasting Free Cash Flow to Equity
The same principles for forecasting FCFF apply to forecasting FCFE. In the case of FCFE forecasting, net income can be estimated by forecasting sales and the company’s net profit margin. In estimating net borrowing, analysts can assume a specified debt ratio (DR) by referring to the target capital structure indicated by management or the average debt ratio among more mature firms in the industry. In cases where depreciation is not the only noncash charge, debt issuance and repayment may need to be forecasted directly on an annual basis (here).

7. Discount Free Cash Flows to Equity at the Cost of Equity
Since FCFE is the after-tax cash flows going to common stockholders, the equity value is estimated by discounting FCFE at the required rate for equity. Below is the expression for a multi-stage FCFE valuation model. The last term is a constant growth formula used to estimate the terminal value.

FCFE Valuation

This formula assumes all cash flows occur at year-end. Equity value can be adjusted to incorporate the fact that most cash flows occur throughout the year by multiplying the total sum by (1 + r)^0.5.

If a mature firm is believed to already operate in a steady state and growth is expected to remain constant, the following single-stage model can be used to determine the firm equity value.

Equity Value

To determine the equity value per share, divide by the number of shares outstanding. Given the dilutive effect that employee stock options can have on equity, a better estimate can be obtained by adding any fully vested and in-the-money stock options to the denominator.

Concluding Thoughts
An alternative FCFE definition is calculated by examining the uses of free cash flow to equity as opposed to its sources. This serves as a useful consistency check and may better illuminate a company’s capital structure or cash position. Uses of FCFE include (1) increases (or minus decreases) in cash balances and (2) payments to providers of equity capital.

FCFE = ΔCash and cash equivalents + Cash dividends + Share repurchases – New share issuance

Firms often pay out less in dividends than they can afford since they may be uncertain about their capacity to maintain higher dividends and would be reluctant to make any cuts. Firms may also choose to retain excess cash to finance future capital expenditure needs. Dividends are therefore often significantly below FCFE. The proportion of cash paid out to providers of equity capital is calculated using the cash to stockholders-to-FCFE ratio.

Cash to stockholders to FCFE ratio

Ratios less than 1.0 indicate that the firm is paying out less than it can afford to stockholders. If the ratio is over 1.0, the firm is paying out more than it can afford and drawing on existing cash balance or issuing new stock or debt.

Suggested Reading
Aswath Damodaran. Free Cash Flow to Equity Discount Models.


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