Free Cash Flow to Equity Explained

February 24, 20247 min read
Free Cash Flow to Equity Explained
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Key Takeaways 

  • Free cash flow to equity is essentially the amount of cash a company produces that could be available for distribution to shareholders.
  • For stock investors, free cash flow is key to understanding how long a company will likely be able to continue to make dividend payments.
  • While FCFE is a key metric, it can be integrated with other financial analyses for a balanced investment approach.

To make informed decisions based on a company’s ability to generate value for shareholders, stock investors must understand and be able to apply free cash flow to equity (FCFE). In stock valuation and investment analysis, the metric offers views of a company’s financial health as well as its shareholder value.

Here is how to harness free cash flow to equity for smart insights.

The Essence of Free Cash Flow to Equity

FCFE is essentially the amount of cash a company produces that could be available for distribution to shareholders. 

In other words, it is the money a company has available to pay dividends and interest to investors or to repay its creditors.

Unlike net income or earnings, FCFE is a measure of profitability that excludes the income statement’s non-cash expenses. Free cash flow to equity does include spending on assets and equipment in addition to balance sheet changes in working capital.

For stock investors, free cash flow is key to understanding how long a company will likely be able to continue to make dividend payments. They also gain insight into the likelihood a company will raise dividends in the future. 

FCFE Formula

The formula for a company’s statement of cash flows is:

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

Where:

Cash from operating activities is the amount of money a business brings in from regular business activities. 

Capital expenditures are funds a company uses to buy, upgrade, and maintain physical assets such as factories, buildings, and other property, as well as technology and equipment. 

Net debt is arrived at by subtracting a business’s total cash and cash equivalents from its total long- and short-term debt.

FCFE in Action

In a simple FCFE, say a publicly traded company generated $100 million in cash from operations, with capital expenditures totaling $50 million. Net borrowing came to $10 million. Here, the FCFE is $40 million ($100 million – $50 million + $10 million).

Note that if the FCFE is less than the dividend payment and the cost to rebuy shares, the company is utilizing either existing capital or debt for funding, or they are issuing new securities. Investors do not like to see this in an existing or potential investment, low interest rates notwithstanding.

FCFE vs. FCFF 

FCFE differs from free cash flow to the firm (FCFF), which represents the cash flow that is available to all a company’s investors, equity as well as debt. In other words, FCFF is the total cash a company generates, including cash from operating, investing, and financing activities.

On the other hand, FCFE only leaves out the cash generated by investing, and operations activities (minus financing activities). That is because “net borrowing uses” for the calculation equals the debt total repaid. Repayment is a financing activity.

Many investors prefer the FCFE to determine a company’s value. What they wish to see is an FCFE that has fully paid its dividend and share repurchase. If dividend payment funds are markedly less than the FCFE, the company is using the overage to improve cash levels. It also may be using it to invest in marketable securities.

Leveraging FCFE for Company Valuation

Valuation of a company calls for distinguishing between equity value and enterprise value. Equity value is the value that is attributed to shareholders, which excludes all debt and financial obligations, but includes excess cash. Enterprise value is the entire business’s value without accounting for its capital structure.

Determining which cash flow measurement to use depends on the type of value wanted. While the FCFF is used to calculate a company’s net present value, the FCFE is used to find the net present value of equity.

Investors generally favor companies that generate a significant amount of free cash flow. Why? It signals that they are able to pay dividends, pay down debt, repurchase stock, and ultimately grow. It also usually presages increased earnings. Knowledge of free cash flow can guide decisions on buying, holding, or selling stocks.

Dividend Sustainability and Growth Opportunities

FCFE analysis can assess a company’s ability to sustain or increase dividends. Because free cash flow represents the amount of money a company has on hand, which could be used for dividends, it is a key financial metric. 

If a company has a consistently low or negative free cash flow, solvency may require rounds of costly fundraising. It may suffer competitively if it has sufficient free cash flow to maintain operations — but insufficient free cash flow to invest in business growth.

Overall, FCFE indicates a company’s capacity for growth investments or buybacks, enhancing stock value. It can be used to predict the stability of future dividend payments. Companies can use FCFE to buy back shares, which can heighten the remaining shares’ value.

Limitations and Common Pitfalls

As important as FCFE is, it does have limitations and pitfalls. Based on the company’s investment and financing decisions, FCFE can be highly variable from year to year.

Also, the FCFE is dependent upon estimates and assumptions, including the company’s future profitability, growth rate, and working capital. It also assumes future capital expenditures and borrowing needs. Such assumptions may be inaccurate or unrealistic. They may also change due to factors such as market conditions.

While FCFE is a key metric, it can be integrated with other financial analyses for a balanced investment approach. It can be used with the previously discussed free cash flow to firm, for example, as well as operating cash flow (OCF). OCF assesses the cash generated by operations before accounting for any working capital investments or capital expenditures.

Diversification

The FCFE is key for stock investors. However, possessing diversified holdings is key to long-term financial success. An increasingly popular way investors achieve such a risk-mitigating securities mix is by incorporating alternatives into their portfolio.

Alternatives, which include art, real estate, venture capital and more, have low correlation to public markets, rendering them less volatile. One of the leading alternative investment platforms, Yieldstreet, on which some $4 billion has been invested to date, offers a number of accessible opportunities. 

The platform, which seeks to create steady secondary income, has the broadest selection of private-market asset classes available. Investors want holdings that can not only diversify, but that can protect against inflation and even improve returns.

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Alternative Investments and Portfolio Diversification

Alternatives can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

These are actionable insights to help investors identify potential investment opportunities. It helps them make strategic decisions based on a company’s ability to generate shareholder value through cash flows. Despite limitations, FCFE is a crucial metric, as it gauges the amount of cash available to equity holders.

We believe our 10 alternative asset classes, track record across 470+ investments, third party reviews, and history of innovation makes Yieldstreet “The leading platform for private market investing,” as compared to other private market investment platforms.

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