FCFF/FCFE

Definition -
• FCFE or Free Cash Flow to Equity model is one of the Discounted
Cash Flow approaches (along with FCFF) to calculate the Fair Price of
the Stock.
• FCFE measure how much “cash” a firm can return to its shareholders
and is calculated after taking care of the taxes, capital expenditure
and debt cash flows.
About FCFE
• Unfortunately, FCFE model has various limitations like Dividend
Discount Model.
• For example, it is useful only in cases where the company’s leverage
is not volatile and it cannot be applied to companies with changing
debt leverage.
Formula(s)

• FCFE Formula = Net Income + Depreciation & Amortization +

Changes in WC + Capex + Net Borrowings
• FCFE Formula Starting from EBIT
• FCFE Formula = EBIT – Interest – Taxes + Depreciation &
Amortization + Changes in WC + Capex + Net Borrowings
• FCFE Formula Starting from FCFF
• FCFE Formula = FCFF – [ Interest x (1-tax)]  + Net Borrowings
 FCFE Formula Additional Comments

 Net Income is after the payment of Interest expense.

 Net Income can be taken directly from the Income Statement.
Net Income
 You can also find this in the the Cash Flow from Operations if the CFO is prepared using the In-direct method

 Add back all the non cash charges

 Generally this number is found in the Income Statements. In some companies, Deprecation & Amortization head is
(+) Depreciation &
not given separately as these expense gets included in Cost of Goods Sold, SG&A
Amortization
 You can find Depreciation & Amortization figures from the Cash Flow statements (CFO)

 Please note that this cash be either an outflow or an inflow.

 Working capital primarily includes Inventory, Receivables, Payables. You may also include accrued liabilities in this
(+/-) Changes in
formula.
Working Capital
 Short term debt is not included here in the changes in Working Capital

 Critical to determine CapEx levels required to support sales and margins in forecast
 This number can be most easily located from Cash Flow from Investments.
 Please note that not only the Capital Expenditure is taken, we must also include “addition to intangibles”.
(-) Capex
 Intangibles become important for software/knowledge based businesses.

 Like working capital, this number can also be an outflow or an inflow

(+/-) Net
 This includes both the short term debt as well as the long term debt.
Borrowings
 Be sure to include the net figure i.e. Debt Issued – Debt Repaid.
Solution –
Using the Net Income FCFE Formula
FCFE Formula = Net Income + Depreciation & Amortization + Changes
in WC + Capex + Net Borrowings
1) Find the Net Income
Net Income is provided in the example = $168
2) Find Depreciation & Amortization
Depreciation & Amortization is provided in the Income Statement. We
need to add the 2016 Depreciation figure = $150
3) Changes in Working Capital
Calculation for working capital.
• From the Current Assets, we take Accounts Receivables and
Inventory.
• From Current Liabilities, we include the Accounts Payable.
• Please note that we do not take Cash and Short Term Debt in our
calculations here .
• See the next slide …………
sz
See for CAPEX calculations.
• Capital Expenditure = change in Gross Property Plant and Equipment
(Gross PPE) = $1200 – $900 = $300.
• Please note that this is a Cash impact will be an outflow of 300
5) Net Borrowings
• Borrowings will include of both the short term and long term debt
• Short Term Debt = $60 – $30 = $30
• Long Term Debt = $342 – $300 = $42
• Total Net Borrowings = $30 + $42 = $72
 Determining the Stock Price using FCFE
•  Alibaba FCFE for following the FCFE example .
• Step 1 – Please prepare a full integrated financial model of Alibaba.
• 
• Step 2 – Find Projected FCFE for Alibaba
• Once you have prepared the financial model, you can prepare the
template like below for FCFE calculation.
• In our case, we use the Net Income FCFE formula.
• Step 3 – Find the present value of explicit forecast FCFE
• In order to find the value of Alibaba from 2015-2022, you need to find
the present value of projected FCFE
• For finding the present value, we assume that the Cost of Equity of
Alibaba is 12%. Please note that I have taken this as a random figure
so as to demonstrate FCFE methodology.
• Here, you can use NPV formula to easily calculate the NPV.
• Step 4 – Find Terminal Value
• Terminal value here will capture perpetuity value after 2022.
• The formula for Terminal value using FCFE is FCFF (2022) x
(1+growth) / (Ke – g)
• Growth rate is the perpetuity growth of FCFE. In our model we have
assume this growth rate to be 3%.
• Once you calculate the Terminal value, then find the present value of
the Terminal Value
Step 5 – Find the Present Value
 Add the NPV of explict period and Terminal value to find the Equity Value
 Please note that when we perform FCFF analysis, the addition of these two items provides
us with Enterprise value
 To the above Equity Value, we add Cash and other investments to find the Adjusted Equity
Value
 Divide the Adjusted Equity Value by total number of shares outstanding to find the Share
Price
 Also, note that my valuation using FCFF approach ($191 billion) and FCFE approach
($134.5 billion) are coming out to be different primarily due to random assumptions of cost
of equity (ke) and growth rates of FCFE
Step 6 – Perform Sensitivity Analysis of Stock Prices.
•You can also perform sensitivity analysis  of Stock prices on FCFE
inputs – Cost of Equity and Growth Rates.
• Like Net Income, FCFE can also be negative. Negative FCFE can
happen due to any or combination of the factors below  –
• Company is reporting huge losses (Net Income is largely negative)
• Company makes huge capital expenditure resulting in Negative FCFE
• Changes in working capital resulting in an outflow
• Debt is repaid resulting in large cash outflow
• an example where we find Negative FCFE.
• We note that in Box Inc, the main cause for Negative FCFE is Net
Losses.
How dividends is different from FCFE
• You can think of FCFE as “Potential Dividends” instead of “Actual Dividends”
• Dividends –
• A part of the earnings each year may paid to the shareholder’s (dividends
payout) and the remaining amount is retained by the company for future
growth.
• Dividends depends on the dividends payout ratio and mature/stable companies
do try to follow stable dividend policy.
• FCFE -
• FCFE is basically the free cash available after all the obligations have been taken
care of (think of capex, debt, working capital etc).
• FCFE starts with Net Income (before the dividends are deducted) and adds all
the non cash items like depreciation and amortization.